Italy is damned if it does, damned if it doesn’t

Italy’s renewed flirtation with economic recession while stuck in its euro straitjacket raises an unenviable policy dilemma for its policymakers. It also raises serious questions about the very heavy economic costs of Italy’s continued euro membership. These considerations do not bode well for either the Italian or the global economies.

Italy’s basic policy dilemma boils down to a choice between two unattractive options.

Should Italy try to stimulate its economy through an expansionary fiscal policy even though that might give fuel to the country’s bond vigilantes who are already concerned about Italy’s budget deficit and its very high public debt-to-GDP ratio?

Or should Italy again try to address its shaky public finances with budget austerity even though that risks deepening any economic recession? Such a deepening in turn might raise serious questions about the country’s ability to service its public debt mountain.

Predictably, the European Commission is now urging Italy to engage in budget belt tightening to restore order to its public finances. It is arguing that given the slowing in its economy, Italy’s budget deficit is already set to rise to well over 3 percent of GDP by 2020.

That in turn would cause Italy’s public debt-to-GDP ratio to rise further beyond its already high level of over 130 percent of GDP thereby raising serious questions about its sustainability.

Understandably, the Italian government rejects the commission’s view. It does so on the grounds that Italy’s own experience over the past decade with budget austerity in a euro straitjacket suggests that such an approach is all too likely to once again be counterproductive.

By deepening the Italian economic recession, such an approach would reduce the country’s tax revenues and cause its public debt-to-GDP ratio to rise rather than to fall.

Rejecting the European Commission’s case for budget austerity, Matteo Salvini, the driving force in the Italian coalition government, is arguing that Italy needs a “budget shock” to kickstart its economy.

Inspired by President Trump’s 2017 tax cut, Salvini is advocating the introduction of a 15-percent flat income tax. He is doing so even though such a policy initiative is expected to cost €30 billion or around 1.5 percent of GDP.

The basic risk to Salvini’s flat tax idea is that it could invite a backlash in the Italian bond market as it would signal that Italy is not serious about restoring order to its public finances. So too would the idea being floated in the Italian Congress of having the government issuing bonds that would be redeemable against the payment of future taxes.

Already before the introduction of a flat tax, the Italian government is having to pay almost 3 percent more to borrow at 10 years than does the German government. After the flat tax is introduced, that interest rates spread must be expected to widen further.

The cost to the Italian economy of any further rise in Italian interest rates is likely to outweigh the benefits to be received from a tax boost. This would especially seem to be the case considering that Italian government bonds constitute around 10 percent of the shaky Italian banking system’s balance sheet.

As such, not only would an interest rate increase discourage investment and make the servicing of Italy’s public debt more difficult, it would also risk further eroding the Italian banking system’s capital base and limiting its ability to lend.

The net upshot is that an Italian government, which has no will to reform its economy and which is stuck in the euro, has no easy way out of the country’s public debt trap.

If it engages in budget austerity, it risks deepening its economic recession and reducing its ability to service its debt. Yet, if it engages in fiscal stimulus, it risks inviting the wrath of its bondholders by increasing the size of its budget deficit and its public debt.

All of this suggests that Italy could be heading soon for a sovereign debt crisis that could have serious implications for the global economy. Being 10 times the size of the Greek economy and having the world’s third-largest sovereign debt market, Italy has the real potential to trigger a global financial market crisis.

The Trump administration would be ignoring ongoing political and economic developments in Italy at its peril. In much the same way as in 2008 the Lehman bankruptcy roiled global financial markets, so to today could an Italian debt crisis do the same. 

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.