When the Covid-19 crisis first struck Italy earlier this year, this column warned it might set off a chain of events that would wreck the Mediterranean country’s economy.
On 10 March (A catastrophe that will cripple Italy), I pointed out that Italy would experience an economic collapse as public debt soared past 150 percent of GDP. About a month later, on 21 April (Debt is the least of Italy’s problems), I unpacked Italy’s abysmal productivity record since joining the Eurozone.
In each case, it was clear Italy faced economic disruptions so severe they could even threaten the survival of the euro as a currency.
While I hate to say I told you so, my forecasts weren’t gloomy enough. Let’s survey Italy’s fiscal and monetary carnage.
Last year, Italy’s public debt stood at 135 percent of GDP. This year it may reach 160 percent. A jump in public debt by 25 percentage over a year is unprecedented, even by Italian standards. And it is still a bit higher than I expected back in March.
If you will excuse some quick maths, what happened is both a numerator and a nominator effect. Italy’s public debt has increased by about €100 billion, while the Covid recession cut GDP by roughly the same amount. But bizarrely, the yields on Italian government bonds also plunged.
Normally, markets should demand higher interest rates when a government’s finances are in freefall. Yet the only thing in freefall is the interest the Italian finance minister must pay on his country’s borrowing. Last Friday, the Italian 10-year bond yield closed at an all-time low of 0.56 percent.
Blame must go to the European Central Bank’s interventions in bond markets. Conducted through the Banca d’Italia, the ECB allowed Rome to indirectly refinance itself. What was the effect of this move?
In December 2019, Banca d’Italia’s assets stood at €961b. By September, this amount had increased to €1.266 trillion – an addition of €305b over just nine months.
Looking a bit deeper into the financials, it appears a major factor in this ballooning debt were “securities held for monetary policy purposes” (up €129b), i.e. the central bank holding government bonds.
Another factor was “longer-term refinancing operations” (up €152b), which is mainly lending to Italian banks so they can use those funds to purchase (surprise, surprise) Italian government bonds.
According to Banca d’Italia’s statistics department, the Italian central bank now holds €529b of government debt – which is about one fifth of all of Italy’s debt.
And just to put it into context, in 2012 at the peak of the Euro crisis that figure was only hovering near €100b.
Simply put, Italy cannot go on like this for much longer. Usually, at 160 percent debt-to-GDP, the game is up and the EU’s debt restructuring team is called in. Indeed, that is what happened across the Aegean when Greece hit similar debt levels, the famous “haircut.”
Rome has a somewhat different idea. Instead of haggling with its creditors, why not ask the ECB to simply forgive the country’s debt?
In an interview with Bloomberg last week, Riccardo Fraccaro, Italian prime minister Giuseppe Conte’s closest aide, put it bluntly: “Monetary policy must support member states’ expansionary fiscal policies in every possible way.” Fraccaro added that this should mean “cancelling sovereign bonds bought during the pandemic or perpetually extending their maturity.”
Fraccaro is not the only Italian politician calling for such a radical step. European Parliament president David Sassoli said in an interview with La Repubblica he would consider it. And the opposition Lega Party’s finance spokesperson Claudio Borghi is also open to the plan. It is thus becoming a cross-partisan call for debt forgiveness.
Alarmed by the prospect of a united Italian front, European politicians are firing back. ECB president Christine Lagarde insisted that debt cancellation “would simply be a violation of the treaty.” But then again, it wouldn’t be the first time a treaty law was bent or ignored to deal with a monetary crisis in Europe.
French finance minister Bruno Le Maire also rejected Italy’s cancellation idea – while standing next to his Italian counterpart at a joint press conference. By saying, “If we are able to easily raise debt on markets today at very low rates, it is thanks to the monetary policy of the ECB,” Le Maire firmly pointed out that cancelling debt is not on France’s Christmas wish list.
That is because Paris would much prefer if European debt was pooled together, rather than forgiven in some member states but not in others. And the louder Rome talks about debt cancellation, the less likely France could convince other EU members to move towards a tighter debt union.
But that means Italy remains in a fiscal and monetary pickle without a realistic escape route.
After the crisis year of 2020, the next 12 months will decide if Italy can get its economy, financial system and public finances under control again.
If not, the debt wound could turn septic for the whole union by increasing the chances of something hitherto unthinkable: Uscitalia, the Italian version of Brexit.