The Eurozone’s moment of truth has arrived with the coronavirus pandemic.
Before the euro was launched in 1999, Milton Friedman and Martin Feldstein warned that it was a major mistake for Europe to establish a monetary union before it had established a political union. They did so because they feared that absent a common budget and a debt sharing arrangement, individual Eurozone member countries stuck within a euro straitjacket would encounter great difficulty in withstanding a major economic shock to their economies.
The coronavirus pandemic will now likely determine whether or not the American economists’ fears were well founded.
It will do so by having delivered a supply side-shock of unprecedented size to Europe in general and to a highly indebted Italy in particular. Indeed, Italy, the Eurozone’s third-largest member country, is now at the epicenter of the pandemic and is being subject to an economic shock of biblical proportions. Not only is the entire country locked down, restricting workers from reaching the workplace. Italy’s all-important tourist sector has been decimated and its European trade partners’ economies too are swooning.
Italy is now bound to have the deepest of economic recessions with output likely to contract by anywhere between 10 and 20 percent in 2020. That is all too likely to cause the country’s public debt to skyrocket to over 160 percent of GDP by year-end. It is also likely to put enormous strain on the country’s rickety banking system by giving rise to a wave of corporate debt defaults and by seriously impairing the value of the Italian banks’ very large holdings of Italian government bonds.
Italy’s prospects of a quick post-coronavirus economic recovery are slim. Stuck within the euro straitjacket, Italy does not have its own monetary or exchange rate policy to jumpstart its economy. With its public finances highly compromised, it also is unable to use fiscal policy to stimulate its economy.
The importance of lacking fiscal policy space to get its economy moving in a post-coronavirus world is best illustrated by comparing Italy to the United States. Whereas the United States has recently approved a fiscal stimulus package of $2 trillion or around 10 percent of GDP to counter the economic effects of the pandemic on its economy, Italy’s poor public finances have constrained it to a EUR 25 billion fiscal stimulus that amounts to little more than 1 percent of its GDP. In other words, on a relative basis, the Italian fiscal response to the pandemic is but one-tenth the size of that of the United States.
Should Italy fail to recover quickly from a deep economic recession, it will continue to experience large budget deficits that would put its public debt on an even more unsustainable path. It would also mean that Italy’s banking system could soon experience a solvency problem as the level of its non-performing loans would continue to increase to very high levels as companies and households struggled to keep afloat.
In these circumstances, it would seem to be only a matter of time before markets test the European Central Bank’s pledge to do whatever it takes to keep Italy in the euro. They would do so as they became increasingly reluctant to buy Italian government bonds for fear of an eventual default. They would also do so as they chose to move their deposits out of the Italian banks to safer havens abroad.
In principle, the European Central Bank and Italy’s European partners could step in to fill the massive financing gap that the markets might leave in Italy’s public finances and in its banking system. However, the amounts of financing that Italy might need would be daunting. Over the next two years, Italy’s government could very well need more than $1 trillion in financial support to roll over its maturing debt and to finance its budget deficit. Meanwhile, its banking system could very well need over $1 trillion to keep it afloat.
In the past, Italy’s northern European partners in general and Germany in particular have been reluctant to have the European Central Bank lend large amounts of money without strict conditions to its member countries. It remains to be seen whether now, at a time that their own economies are under considerable strain, they will be any more forthcoming in their support of Italy. Hopefully, they will rise to the challenge. If not, we should brace ourselves for an Italian exit from the euro that would almost certainly roil the world’s financial markets.
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.