Nowadays, when sorrows come to the global economy, they would seem to come not as single spies but as battalions. First, we have a full- blown currency crisis in Turkey. Then we have another such crisis in Argentina.
Before either of those two crises are resolved, we now have Italy plunged into a political crisis that could end up with Italy eventually being forced out of the euro.
{mosads}A key difference between Italy on the one hand and Argentina and Turkey on the other is that Italy is a country of systemic importance to the global economy. As such, it has the potential to trigger a global economic and financial market crisis.
It has the potential to do so in much the same way as the September 2008 Lehman bankruptcy had the potential to set off the worst global economic recession in the post-war period.
One indication of Italy’s systemic importance is the very size of its economy. Being the eurozone’s third-largest economy, it is 10 times the size of that of Greece. As such, it makes it difficult to contemplate how the euro could survive in anything like its present form were Italy forced to exit that monetary arrangement.
Another indication of Italy’s importance to the global economy is the fact that it has the world’s third-largest sovereign debt market after that of the United States and Japan, with a total public debt of more than $2.5 trillion.
Were Italy to default on that debt, as would almost certainly occur were its government’s borrowing cost to increase should Italy leave the euro, it is difficult to contemplate that there would not be a full-blown European banking crisis that would reach America’s shores.
Among the reasons to fear that Italy could be heading for a full-blown economic crisis is the precarious sate of its economy. Remarkably, Italy’s per capita income is lower today than it was on the eve of the country’s euro adoption in 1999.
Equally remarkable is the fact that over the past decade, Italy has experienced a triple-dip recession, and it is yet to regain its pre-2008 crisis output level.
As a result of its sclerotic economic performance and a 20-percent loss in international competitiveness, Italy’s financial market vulnerabilities have only increased. Its public debt-to-GDP ratio has now risen to its present level of 133 percent of GDP, which makes Italy the second-most-indebted country in the eurozone after Greece.
At the same time, a lack of economic growth has contributed to the weakening of the Italian banking system. That weakness is underlined by a level of non-performing loans that amount to around 15 percent of the banking system’s balance sheet.
To date, Italy’s economic vulnerabilities have been masked by a highly favorable global liquidity environment as well as by the large scale European Central Bank’s (ECB) buying of Italian government bonds as part of its quantitative easing program.
However, this era of easy liquidity conditions would seem to be nearing an end. Over the past year, the benchmark U.S. 10-year Treasury bond yield has doubled to its present 3-percent level, while the ECB is scheduled to wind down its bond-buying program by year-end.
The prospect of a more challenging global liquidity environment makes it all the more urgent that Italy somehow finds the way to reform its economy to deliver the economic growth that would allow it to reduce its economic vulnerabilities. However, this now appears very unlikely to occur given the country’s deepening political crisis.
Following their major victories in Italy’s March 2018 parliamentary election, the populist Five-Star Movement and the far-right League now, between them, command a parliamentary majority.
This puts Italy on a collision course with its European partners since those two parties wish to roll back the economic reforms of the preceding government. They also plan to introduce budget-busting measures like a basic income program and a flat income tax.
To complicate matters, Italy is now in the midst of a constitutional crisis following the controversial use by the president last weekend of his veto power to prevent the Five-Star Movement and the League from forming a government.
This is likely to result in the calling of new parliamentary elections, most likely in October. Such elections could turn into an effective referendum on Italy’s continued eurozone membership, which would usher in a prolonged period of economic uncertainty.
Given all of our close economic and financial market ties with Europe, one would think that a healthy European economy is in United States’ vital economic interest. This would make it all the more urgent that the Trump administration pivot quickly from a confrontational to a cooperative policy stance toward Europe.
However, judging by the administration’s seeming commitment to a narrow, “American First” worldview, I am not holding my breath for this to happen.
Desmond Lachman is a resident 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.