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How worried should we be about an Italian debt crisis?

Silvia Merler, Oliver Blanchard & Jeromin Zettelmeyer, (2018), “How worried should we be about an Italian debt crisis?”, Bruegel, 28 May

Earlier PIIE research examined whether rising interest rates might unleash a debt crisis in Italy. The answer was “no,” under two conditions: First, that rising interest rates reflected economic recovery; and second, that the Italian government would be prepared to cooperate with European authorities—the European Union, the European Stability Mechanism (ESM) and the European Central Bank (ECB)—to manage a loss of market confidence. Ten months later, these conditions no longer hold. Political backlash to slow growth and immigration has produced the least cooperative government imaginable, a coalition between the left-populist Five Star Movement (M5S) and the right-populist Lega. And borrowing costs have started to rise in reaction. Does this mean that a crisis is imminent? If so, how bad would it be?

How bad would a debt crisis be?
The second question is easier to answer than the first. A crisis could be horrific, for two reasons. First, none of the powerful stabilisation instruments that the euro area has developed over the years could be deployed to rescue Italy. Following crisis-related downgrades, Italy would no longer be eligible for the ECB’s quantitative easing bond-purchasing program. The ECB would stop accepting Italian bonds as collateral. Access to emergency support programs—the ESM, and through it, the Outright Monetary Transactions (OMT) program—would be conditional on fiscal adjustment, the opposite of what Italy’s new government has promised. Unless the government were to change course, it would be forced to exit the euro, even if this is not its current plan. And second, there is Italy’s interconnectedness and size. With the ECB using all available tools to limit contagion, the euro might survive Italexit. But an exit would nonetheless put Italy, the euro area economy, and the European Union in deep distress. With credit, investment, and consumer confidence collapsing, Italy would enter a deep recession. Redenominating assets and liabilities of Italian corporates and banking would trigger bankruptcies and legal conflict. The resulting acrimony—both within the country and across Europe—would dwarf what was witnessed during the 2010–12 crisis. If Italy also exits the European Union, a massive trade shock would aggravate the financial crisis and recession in Italy and Europe at large.

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