Markets have not distinguished themselves in anticipating European economic crises. In late 2009, on the eve of the Greek sovereign debt crisis, Greek government bonds traded with a yield that was barely above that of German government bonds. A year later, the Greek sovereign debt crisis shook U.S. and world financial markets and Greece eventually defaulted on its loans. That was then the largest sovereign debt default on record.
Judging by the relative calm in the Italian sovereign debt market, one wonders whether the market is making a similar mistake.
Discounting the possibility of an Italian sovereign debt market crisis despite that country’s deteriorating economic fundamentals could be of considerable consequence for the U.S. and world financial markets, since Italy has an economy and a government bond market that is some 10 times the size of that of Greece.
Making the relative calm in the Italian sovereign debt market all the more surprising is the marked deterioration in Italy’s public debt fundamentals. That deterioration sits oddly with Italian 10-year government bond yields trading at only some 180 basis points higher than their German counterpart.
The most striking deterioration in Italy’s debt fundamentals is the prospective rise in that country’s debt service payments. It is not only that at 145 percent of GDP, Italy’s public debt today is around 15 percentage points of GDP higher than it was at the time of the 2012 Italian sovereign debt crisis; it is that, courtesy of European Central Bank (ECB) monetary policy tightening to combat inflation, Italian 10-year bond yields have risen from less than 1 percent in 2021 to around 4 ¾ percent today.
At current government bond yields, the prospect that Italy could grow its way out from under its debt burden appear to be dim. This is especially the case given the country’s dismal past economic growth performance, underlined by the fact that Italian per capita income today is little changed from its level some 15 years ago. It also does not help that it appears that Italy will soon follow Germany into economic recession as a result of the ECB’s monetary policy tightening.
Another major change for the worse to which the markets seem to be turning a blind eye is the ECB’s shift from a policy of aggressive quantitative easing to one of quantitative tightening. This means an end to the former ECB policy of buying the totality of the Italian government as an important part of its quantitative easing policy. It also limits the likelihood of large-scale ECB Italian bond purchases barring a disorderly spike in Italian bond yields. From now, the Italian government will need to meet most of its borrowing needs from the market all too probably at higher interest rate cost.
Further clouding the Italian bond outlook is the erratic behavior of the right-of-center Italian government under the leadership of Prime Minister Giorgia Meloni. This behavior is underlined by the recently proposed and ill-considered windfall profit tax on the banks and by a number of market unfriendly economic reforms. This hardly inspires confidence in the Italian government’s ability to promote economic growth or to deal with a potential debt crisis.
All of this is not to suggest that a full-blown Italian sovereign debt crisis is imminent. However, it is to say that the ECB needs to be careful to avoid monetary policy overkill in its quest to regain inflation control. The last thing that a highly indebted and sclerotic Italian government now needs is another economic recession and yet higher interest rates that will only worsen the country’s public finances.
American Enterprise Institute senior fellow Desmond Lachman was 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.