Why Italian instability could derail the global economy

It would be all too tempting for the incoming Trump administration to dismiss last weekend’s Italian referendum as a nonconsequential vote on a distant shore that will have little bearing on the U.S. economy.

Sadly, that would be a big mistake.

{mosads}Unlike Greece, Italy has a large economy that is of considerable systemic economic importance. It also has the most compromised of economic fundamentals, which makes it singularly ill-prepared to weather a prolonged period of political instability.

As such, it has the potential to both roil global financial markets and to derail the global economic recovery.

The incoming Trump administration would be ignoring Italian political and economic developments at its peril, particularly in light of the Italian government’s resounding defeat in last weekend’s referendum.

After all, Italy is the eurozone’s third largest member country, with a banking system that has around $4 trillion in assets. It also happens to be the world’s third largest government bond market, with government bonds in excess of $2.5 trillion.

These factors make Italy’s economic well-being essential for the euro’s longer run survival.

Yet they also make Italy too big for Europe to save in the event that it were to experience a full-blown economic and financial crisis.

In the run up to last weekend’s Italian referendum, money flew out of Italy at an alarming rate as Italians fretted about the stability of an Italian banking system with nonperforming loans totaling as much as 18 percent of its balance sheet. Indeed, European Central Bank data on Italy’s TARGET2 balances — the eurozone’s payment system — through September 2016 suggest that capital flight from Italy has been on a scale of that experienced at the height of the eurozone debt crisis in the first part of 2012.

In the months immediately ahead, there is every prospect that capital flight out of Italy will gather pace. It will do so as Italian bank depositors fear a prolonged period of political instability that will highly circumscribe the Italian government’s ability to address the country’s banking sector challenges.

In the immediate aftermath of last weekend’s referendum, Prime Minister Matteo Renzi has followed through on his pledge to resign if he lost that referendum. While Renzi’s resignation is unlikely to prompt early Italian elections, it is likely to mean that Italy will have a government that will have little authority to govern given the overwhelming margin by which it lost the referendum.

It is also likely to put wind in the sails of the radical Five Star Movement party that is committed to taking the country out of the euro.

A weak government saddled with an unreformed Senate that can continue to block legislation is the last thing that a country needs when its economy is as sclerotic as that of Italy, when its government is over-indebted, when its banks are saddled with a mountain of nonperforming loans and when the country has become internationally uncompetitive.

Without a strong government, there is little prospect for the type of economic reforms that might kick-start the Italian economy and allow it to grow out of its public debt and banking sector problems.

There is also little prospect that the country will extricate itself from its downward economic and political spiral.

Should the Italian economy lurch toward an economic and financial crisis over the next few months, it would be doing so at an inopportune time for its major economic partners.

France is scheduled to go to the polls in April and May, while Germany is expected to hold its parliamentary elections in September. With Marine Le Pen of the French National Front rising in the polls and with German Chancellor Angela Merkel’s political star waning, these elections will make it very difficult for both the French and the German governments to offer support to Italy on the scale that they have done in previous Italian economic crises.

All of this suggests that President-elect Donald Trump could be tested by a European economic baptism of fire in the early months of his administration as the Italian economic crisis comes to a head.

Hopefully, Trump will have the flexibility to adapt his proposed U.S. economic program to the new realities of the global economy. One also has to hope that he will tone down his confrontational rhetoric on international economic issues and provide the sort of global economic leadership that might limit the fallout from an Italian economic and financial market meltdown.

If he does not do so, we should brace ourselves for some very rough sledding both in the U.S. and the global economies in the years immediately ahead.

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.

The views expressed by contributors are their own and not the views of The Hill.