In the past year, Italy has been a source of a lot of investor angst, with 10-year yields reaching levels not seen since 2014. Despite the simmering crisis there, I am not concerned about short- or medium-term outcomes because I believe the euro system has more stability than is appreciated. Below I want to outline how I think about Italy and what that will mean regarding the range of potential outcomes economically.
Italy as a paragon of fiscal virtue
Let’s look at how the Italians view themselves, first, because I think it’s important regarding how the politics will play out. I wrote a post in June on how Italian political figures might say that “at any point in time over the past 25 years, Italy has had a primary surplus (before paying interest) among the highest in Europe”. And what they mean by that is that Italy has adhered to the EU’s stability and growth pact rules better than anyone. The problem is a legacy government debt from the period before the euro.
So, Italian politicians see the present debate over Italy’s attempts to jumpstart demand with that backdrop. They reasonably object to the imposition of fiscal constraints given how well they have adhered to the EU’s guidelines in both good and bad times. And so, the talk of Italy as a deficit sinner and one of the four PIGS is met with a righteous sense of anger.
But Italians want the euro
Negotiating positions for the Italian government are restricted largely because polls show a super-majority of Italians favour remaining in the eurozone. Only one-quarter of Italians back exiting the euro. And so that means, the political battles between Rome and Brussels will play out without Italexit as a reasonable concern for anyone. Instead, worst case scenarios will revolve around high Italian bond yields damaging the Italian economy, Italian bank balance sheets, and starting another round of increasing Italian distressed debt.
In that context, it makes more sense to sell private Italian assets than sovereign Italian assets simply because the Italian government is too big to fail. When push comes to shove, the EU will find a way to prop up Italian government bonds, likely with the Italian government bending to Brussels’ will on deficits and stimulus. If the EU and the ECB were to make the mistake of allowing the Italians to default, all hell would break lose and we would have a Lehman Brothers-style panic on our hands, with unknowable consequences.
And remember, we’ve seen this movie before. Despite all the talk of Grexit, Syriza never said it wanted to leave the eurozone. Even the hard-charging finance minister Yanis Varoufakis said he unequivocally backed staying in the eurozone. As I explained in late May, Syriza “merely wanted to assert more sovereignty over its fiscal options because of the severity of the post-financial crisis downturn. In that case, voters backed this assertion of fiscal sovereignty. But Syriza was thwarted as the ECB pulled the plug and forced the Greeks to toe the line.”
Where does that leave us in Italy?
It’s unclear whether the fiscal situation in Italy will end in a showdown. If it does, Italian bonds will sell off even more. And faced with a worsening economy and the potential of private sector defaults, I believe the Italian government will have to respect the stability and growth pact in some form.
So, over the short-to-medium term, this is a fake crisis in Italy. Italian government debt will only be allowed to sell off so much before we see official intervention. The real threat is longer-term. A stand-off could do real damage to the Italian economy, enough so that it raises the desire of Italians to exit the euro. But we would need to see a doubling in pro-Italexit sympathy for a euro exit scenario to be a real threat. And we can’t get there overnight.
In the meantime, expect Italian government bond yields to remain elevated, causing Italy to underperform economically for the foreseeable future.
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