The spread between Italian and German bonds rose last week to around 2 percentage points. Why should that be so? Unlike in 2012, there is no looming threat of a liquidity crisis. The European Central Bank’s Pandemic Emergency Purchase Programme will probably ensure that the Italian government is safe to issue whatever debt it needs this year. Rather, Italy’s problems are of a different nature.
As of the end of last year, Italy’s public sector debt was 136 per cent of gross domestic product. Over the previous decade, it had increased by 30 percentage points. If you assume that what the IMF calls the Great Lockdown leaves Italian GDP 10 per cent lower than in 2019, and if outstanding debt increases by 20 per cent, then its debt-to-GDP ratio balloons to 180 per cent. When debt rises and output falls at the same time, these ratios shoot up fast.
So what should Italy do? I see three courses of action. My expectation for this week’s virtual meeting of EU leaders is a compromise on a restructuring fund. Once the applause fades and people look at the details, they will realise it will have no macroeconomic relevance. This will leave the ECB, once again, as the only EU institution that matters. Its pandemic programme will do the necessary this year.
But what about afterwards? The only available instrument left for the ECB to deploy is former president Mario Draghi’s “outright monetary transactions” — the never-launched programme that will forever be associated with his 2012 promise to “do whatever it takes” to save the eurozone. This would allow the ECB to undertake unlimited purchases of Italian debt, but only if Italy applies to the European Stability Mechanism for an enhanced conditions credit line. This is like an overdraft facility with some mild conditionalities. It is not the facility itself that matters, but its link to an ECB programme.
Yet there does not appear to be a majority in the Italian parliament for ESM support. Nor is it clear that the ECB would agree to trigger OMT. The argument is that it is not intended to address looming insolvency.
Another course is for Italy to default, or seek a debt restructuring. This may be compatible with eurozone membership, but would need ECB involvement as otherwise Italian debt would lose its status. Domestic banks are another priority. As they hold much of Italy’s sovereign debt, default could lead to bank failures. Still, as Irish economist Karl Whelan points out, Italy could “haircut” its bonds and win enough savings to nationalise and save them. Investors would be wiped out but deposits saved.
Finally, there is always the spectre of a eurozone exit. It is not a probable event. But then again, nor was Brexit. As happened in the UK, Italians are beginning to blame the EU for everything that is going wrong. I heard a story of someone blaming the Dutch for the delay in their unemployment payments. This is an absurd accusation, of course. But the Five Star Movement, the senior partner in the ruling coalition, may see an opportunity to revive its flagging political support and play to rising anti-EU sentiment. It is hard to overstate Italy’s dramatic turn to Euroscepticism. It will not go away when lockdown ends.
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Emmanuel Macron is right to warn about the unravelling of the EU. I fear, however, that the French president will avoid a long-overdue confrontation with Germany, which remains sceptical about the idea of eurozone bonds. Unless he is willing to get such a bond under way with a smaller group of member states, his threat is cheap talk. If Giuseppe Conte, Italian prime minister, acts in the spirit of his predecessors, he will agree to a foul compromise and discover later that the costs outweigh the benefits. Once that realisation sets in, there will not be many good options left.
When northern Europeans discuss eurobonds or similar instruments, they frame the debate in terms of solidarity and charity or, in the Dutch case, as a gift. They do not see it as risk insurance. There is zero appreciation in Germany, and, I suppose, the Netherlands too, of a potentially catastrophic downside to their financial sectors and their economies were Italy to default.
Yet, default becomes increasingly probable if politics rules out alternatives. If or when that happens, the eurozone will not be ready.
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