Rome's budget antics threaten to drag EU and euro into crisis

Washington

US policymakers and world financial markets are surprisingly calm about the deepening Italian economic crisis. Italy's economy is 10 times larger than Greece's. If it fails, the euro cannot survive. It would also be too costly for its European partners to save.

Unlike Greece, Italy has a populist government in place that is flouting the rules of European monetary union. This would make it even more difficult for its European partners to save, for fear of sending the wrong message to other euro area countries.

Italy's economy is the euro area's third largest. Equally important, it has the world's third largest sovereign debt market after the US and Japan, with more than US$2.5 trillion in outstanding government debt.

An Italian debt default would trigger a European banking crisis with global economic and financial market ramifications.

Italy has all the preconditions for another round of the sovereign debt crisis, which Europe has dealt with for almost a decade. It is not simply that with a public debt to GDP ratio of more than 130 per cent it is, after Greece, the euro area's second most highly indebted member. The country suffers from a sclerotic and uncompetitive economy. Its shaky banking sector will probably soon need a government bail-out.

One indication of Italian banks' weakness is a non-performing loan ratio that remains well more than 10 per cent of their balance sheets. Another is that these banks hold more than 400 billion euros (S$636 billion) in Italian government bonds. This creates a dangerous "doom loop" between Rome and the banks.

Italy needs faster economic growth and greater budget discipline to put its public debt on a more sustainable path. This is more urgent in the light of the prospective tightening in the global credit market cycle and as the European Central Bank's government bond-buying programme winds down.

Apparently, Italy's populist government has an alternative view of basic public finance logic. Rather than committing to a reform programme that might deliver faster growth, the government seems determined to roll back the modest labour market and pension reforms of its predecessor.

Similarly, rather than committing to reducing its budget deficit, Rome is intent on delivering on its costly election campaign promises, even though this might mean running up budget deficits. This would be in flagrant violation of euro area rules, which state there must be no increase in structural deficit. As an indication of the Italian government's disregard for these rules, it has announced lavish public spending plans that will involve an increased budget deficit of 2.4 per cent of GDP next year.

In defending its budgetary largesse, Italy is engaging in wishful thinking that somehow the country will grow out of its debt problem. Never mind that its budget policies have already resulted in a spike in long-term Italian interest rates to 3.4 per cent, which is bound to deal the economy a serious blow. Investor and consumer confidence are likely to be shaken by the prospect that the country is on a collision course with its European partners.

Rudi Dornbusch, the late Massachusetts Institute of Technology economist, never tired of warning that a crisis takes a much longer time coming than people think, and then it happens much faster than they would have imagined. Judging by the reckless budget path the Italian government has chosen and by markets' slow reaction to these developments, his dictum might be more relevant amid the Italian economic and political drama. OMFIF