Economist Herb Stein famously said that if something cannot go on forever, it will stop. If ever Stein’s dictum had applicability, it is to Italy’s currently unsustainable public debt situation. Once the European Central Bank (ECB) stops buying Italian government bonds on the massive scale that it has been doing over the past 18 months, Italy likely will be at the center of another round of the European sovereign debt crisis.
It would be a gross understatement to say that Italy’s public finances are unsustainable. Italy’s public debt to GDP ratio skyrocketed during the pandemic to over 155 percent of GDP. That was the highest such ratio in the country’s 150-year history and well above its level after World War II. At the same time, the country’s budget deficit blew out to over 9 percent of GDP in both 2020 and 2021.
In the period ahead, Italy’s public finances could be further compromised should the country’s shaky banking system need meaningful public support. Underlying the risk of such an eventuality is Standard and Poor’s recent estimate that in 2022 the share of non-performing loans in the Italian banks’ balance sheets could rise to 10 percent.
Italy’s past history of sclerotic economic growth offers little hope that the country will be able to grow its way out from under its public debt mountain. Since joining the Euro in 1999, the Italian economy has virtually stagnated while Italian income per capita today is significantly lower than it was some 20 years ago. The prospect of yet another European wave in the pandemic casts a dark cloud over Italy’s tourist-dependent economy and raises the specter of yet another Italian economic recession.
Italy’s unfortunate experience with budget austerity during the 2010 European sovereign debt crisis illustrated the futility of trying to restore public debt sustainability through budget-belt tightening in a country that is stuck in a Euro straitjacket. Having given up its currency for the euro in 1999, Italy can no longer resort to currency depreciation as a means of boosting its export sector to offset the contractionary impact on aggregate demand of budget austerity. Trying to do so would likely result in a recession that would negate any benefit to Italy’s public debt situation to be derived from public spending cuts and tax increases.
Over the past 18 months, the Italian government has been able to access the international capital market on very favorable terms despite the highly compromised state of its finances. This has been made possible thanks to the unusually large ECB Italian government bond purchases under the ECB’s Pandemic Emergency Purchase Program. Indeed, ECB Italian bond purchases under that program were approximately the same size as the Italian government’s gross borrowing needs.
Unfortunately for Italy, the ECB cannot be expected to continue buying Italian government bonds indefinitely on anything like the scale that it has been doing to date. Against the background of rising European inflation, the ECB has already announced that it will be ending its Pandemic Emergency Purchase Program in March 2022 and replacing it with a more modest bond-buying program. Should European inflation continue to rise, it will be only a matter of time before the ECB chooses to totally phase out its bond-buying activities like the Federal Reserve has already announced it will soon do.
It is all too likely that when the music of massive ECB bond-buying stops playing, domestic and foreign Italian government bond investors will focus their attention on that country’s dismal public finances. When that happens, one must hope that U.S. and world economic policymakers are not caught out as flat-footed, as they were in 2010 when Greece’s economic troubles triggered a European sovereign debt crisis. This is especially the case considering that this time around the European sovereign debt crisis will be centered on Italy, a country whose economy is about 10 times the size of Greece’s.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.