Judging by the current calmness in the Italian bond market and the euro’s strength, one could be forgiven for thinking that all is well with Italy, the eurozone’s third-largest economy. This is all the more surprising considering the dramatic gains made by the populist parties in Italy’s recent parliamentary elections.
Those electoral gains heighten the chances that Italy will continue to lag economically behind its northern European neighbors and that it will fail either to grow its way out of its public debt problem or to shore up its shaky banking system.
{mosads}They also heighten the risk that Italy will drag Europe into another round of the eurozone sovereign debt crisis when the European Central Bank ends its current bond buying program by year end.
In the three weeks following Italy’s March 4 parliamentary elections, Italian government bond yields have been little changed at under 2 percent. Strikingly, this is significantly below the 3 percent that the U.S. government currently pays on its borrowing. At the same time, the euro has continued to gain strength against the U.S. dollar.
This has been the case despite the fact that the two populist parties, the Five-Star Movement and The League, captured more than 50 percent of the Italian vote between the two of them. It has also been the case despite the increased signs that those two parties could join forces to form the next Italian government.
In the almost 20 years since Italy joined the euro, its economic performance has been highly disappointing, and the country’s per capita income has actually declined. That dismal economic performance has mainly been the result of the country’s inability to generate the sort of productivity growth that its northern neighbors like Germany have been able to do on a consistent basis.
Stuck within a euro straitjacket that denies Italy the option of devaluing its currency to restore competitiveness, over the past two decades, Italy has managed to lose more than 20 percent in competitiveness to Germany. Little wonder then that the income gap between Germany and Italy has widened to a disturbing level.
Italy’s lack of economic growth over the past two decades has been accompanied by increased economic vulnerabilities. Among the more important of these vulnerabilities has been the steady rise in its public-debt-to-GDP ratio to 133 percent, making the country the eurozone’s second-most indebted country after Greece.
Over the same period, there has been a disturbing weakening in the Italian banking system. This is evidenced by a rise in non-performing loans to around 15 percent of the Italian banking system’s overall balance sheet.
Italy desperately needs to grow its economy if it is to reduce its public debt and banking sector problems. This is especially the case considering that global liquidity conditions are likely to become more difficult in the period ahead as the Federal Reserve raises interest rates.
It is also the case considering that the European Central Bank is intimating that it will soon end its bond-buying program, which includes large monthly Italian government bond purchases.
Sadly, this month’s Italian election result substantially diminishes the chances that Italy will get itself onto a better economic growth path than it has experienced over the past two decades.
Both the Five-Star Movement and The League favor rolling back the modest economic reforms of the previous government in the area of pensions and the labor market.
Meanwhile, both parties are likely to be very much less disciplined than their predecessors in their pursuit of budget policy, and they are likely to adopt a more confrontational stance in their dealings with Europe.
All of this matters for both the eurozone and for the global economy. It is difficult to imagine that the euro will survive if a major economic crisis were to visit Italy. The Italian economy is simply too big for Europe to save.
Similarly, it is difficult to think that global financial markets would not be roiled by any prospect that Italy, the world’s third-largest sovereign bond market, might be forced to default on its public debt mountain.
In seeming to ignore the major political change that has occurred in Italy’s very troubled economy, markets are not doing us a service. They are all too likely to lull the new Italian government into a false sense of security about the state of the economy. They are also likely to reduce the urgency for remedial economic measures.
One has to hope that Italy’s European partners are not similarly lulled into a false sense of security about Italy’s longer-run economic prospects. Rather, one must hope that they are taking full advantage of the market’s present calm to prepare themselves for the fallout from Italy’s eventual day of economic reckoning.
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.