Italy never should have joined the euro, and the ECB can’t rescue it from its next crisis

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MarketWatch, 12 June 2018.

Italian financial tremors are again rumbling dangerously. Yields on the country’s 10-year government bonds, which briefly topped 3% when President Sergio Mattarella temporarily stopped the Five Star Movement and the League from forming a government, appear primed to rise even higher, potentially plunging Italy and the eurozone in an unmanageable crisis. 

Italy is not just a deeply troubled country, it is also large. Its chaotic banking sector is the euro area’s third largest, following those in France and Germany. The Italian government’s debt, at €2.5 trillion, is about the same size as the debt owed by the French and German governments, and is larger than the combined government debt of Spain, Portugal, Greece, and Ireland, the four countries that needed financial bailouts. An Italian financial crisis would quickly break through the defences euro area authorities have constructed.

This need not have been. In the 1990s, thoughtful observers understood that Italy did not belong in the euro area. Italy could not give up its own monetary policy and currency, the lira. Over three decades, between 1970 and 1999, the lira had steadily lost over 80% of its value relative to the German mark. As the new millennium neared, Italy was being out-competed by emergent East European economies and even more dramatically by China. Unable to raise productivity growth, Italy would need more lira devaluations. 

However, Italy’s top economists and finance officials were keen, indeed desperate, to join the euro area. They subscribed to the vincolo esterno (external constraint) proposition. They insisted that lacking the escape valve of an ever-depreciating lira, Italy’s political leaders would have no option but to enforce sound fiscal and structural policies to secure a better future for Italians. EU scholars Kenneth Dyson and Kevin Featherstone say Mario Draghi, currently president of the ECB and then director general of the Italian treasury, “believed in his soul” that the euro would enforce the discipline Italian governments needed. 

Hubris won the day, and Italy joined the euro area at its inception on 1 January 1999. But Italy’s fractious governments lacked the patience and durability to deal with the country’s endemic problems. The Italian economy fell into near-zero productivity growth, and despite the benefit of a buoyant world economy from mid-2003, the unemployment rate on the eve of the global financial crisis in 2007 was nearly 7%. Italian banks were eking out meagre profits, and the government’s debt was nearly 100% of GDP.

The global crisis between 2007 and 2009, and then the 2011-2013 euro area crisis magnified Italy’s pre-euro economic and financial fragilities. The euro’s central flaw now came to the fore: a single monetary policy could not work for the strong Germany economy and for an increasingly decrepit Italian economy. Making matters worse, the ECB adopted a much tighter monetary policy stance than either the US Federal Reserve or the Bank of England. By mid-2011, amidst over-the-top fiscal austerity demanded by euro area authorities, Italy desperately needed easy monetary policy and a large euro depreciation.  

Instead, on 7 July 2011, the ECB made a catastrophic error by raising interest rates, sending financial markets into panic. Between mid-2011 and mid-2012, financial turmoil reigned through much of the euro area, especially in Spain and Italy.

Italy never recovered from that trauma. In July 2012, the ECB’s Draghi tried to heal the wounds with his dramatic promise to do “whatever it takes” to rescue euro area countries. That led to the Outright Monetary Transactions (OMT) shield, which carried the promise that the ECB would buy unlimited quantities of a member country’s bonds. But although markets calmed down, Italian interest rates remained too high, which, combined with unremitting fiscal austerity, mired the Italian economy in recession. 

With the ECB continuing to deliver only niggardly monetary stimulus, the unemployment rate soared, reaching nearly 12% by early 2013. Even the jobs available were precarious, and, feeling a sense of hopelessness, large numbers of Italians stopped looking for work. For too many, the financial stress was acute. Anti-European sentiment spread. In the February 2013 elections, the anti-establishment and anti-euro Five Star Movement emerged as a potent electoral force with a quarter of the vote.

A final economic pathology set in when the ECB refused to introduce a bond-buying quantitative easing (QE) programme of the type that the US Federal Reserve had initiated in December 2008. Labouring under a GDP contraction of nearly 5% from late 2011, the Italian economy was pushed into deflationary zone by mid-2013. While low inflation is generally desirable, inflation that is too low (‘lowflation’) causes people to postpone purchases, economic growth slows down further, and debt burdens rise. That is precisely what happened in Italy. By the time the ECB introduced its much-delayed QE programme in January 2015, Italy was in a lowflation trap: expecting modest, if any, price increases, Italians held back spending, which kept inflation low.

Today, the Italian economy stands delicately poised. With the inflation rate stuck at around 0.6%, Italian businesses and consumers face real interest rates (the rate adjusted for inflation) that are over 2%. They cannot afford such high rates – the economy’s productivity has stagnated for years and combined with a sharp decline in investment during the recession years, GDP is projected to grow at less than 1% a year over the next three to five years. Indeed, with the momentum of world trade growth fading, Italy’s GDP growth could relapse into recessionary conditions. If so, borrowers will struggle to repay loans to the perennially weak Italian banks. The government’s tax receipts will fall, making it harder to repay its huge debt burden.

If Italy falls into another crisis, the ECB, unlike in July 2012, may be powerless to diffuse it. In principle, the ECB can purchase unlimited quantities of Italian bonds, which would reduce the interest rates and make the crisis go away. But already holding about a quarter of the Italian government’s bonds, the ECB will face the risk of large losses if the government defaults. 

Northern euro area officials, particularly the Germans, are anxious, fearing they would ultimately bear the ECB’s losses. They want QE to end. Even Peter Praet, the ECB’s dovish chief economist, is ready to declare victory – the euro area economy is on the mend and inflation will soon rise, he says. Such optimistic projections ignore signs of the euro area’s slowing growth momentum. They fail, in particular, to understand the trap Italy is in. If the ECB winds down its QE, the euro will strengthen and Italian real interest rates will rise further, increasing Italy’s financial fragility. In such an environment, triggering the never-used OMTs would spawn fractious negotiations on fiscal austerity with Italian authorities, and would create a political crisis well before the ECB extended any financial help to Italy.

The new Italian government’s policy priorities are obviously at odds with budget realities. But quite simply, once Italy misguidedly entered the euro area, a tragedy was fated. Now, tremors from the Italian fault line are set to spread in cascading earthquakes through euro area and global financial systems. An Italian recession could create unbearable pressure on the country’s banks still labouring under the burden of a large volume of non-performing loans. Cracks in a few banks would fracture financial fault lines throughout Europe. Adding to the woes, as slowing tax receipts cause the government’s budget deficit to increase, investors will demand higher interest rates, placing the economy and banks under even greater stress. With its large size and deep vulnerabilities, Italy could push the euro area and the world on to the wrong side of the tipping point.