About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was 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 late economist Herb Stein famously observed that if something cannot go on forever it will stop.
If ever Stein’s observation had applicability, it has to be to the European Central Bank’s past massive purchases of Italian government bonds to keep Italy afloat. Now multi-decade-high inflation has forced the ECB to turn off the monetary-policy spigot, it’s only a matter of time before the ECB is confronted with another Italian sovereign debt crisis.
Much like the Federal Reserve, the ECB turned to extraordinary monetary policy to support the euro zone economy as the 2020 Covid-induced recession took hold. Not only did the ECB maintain negative policy interest rates, it also expanded the size of its balance sheet by a staggering $5 trillion through massive government purchases over the past two years.
A distinguishing characteristic of those bond purchases is that they were disproportionately directed at member countries with weak public finances, particularly Italy. This targeting allowed the ECB to more than cover the entirety of the Italian government’s net bond issuance over this period. It also allowed the ECB to keep Italian interests at historically low levels with respect to Germany, despite Italy’s deteriorating public finances.
Fast forward to today, and we find that the ECB is being forced to follow a very different monetary-policy approach. Euro-zone inflation has spiked to more than 10%. To regain control over price increases, the ECB is now having to slam on the monetary-policy brakes. After already having raised interest rates to 2%, ECB President Christine Lagarde is emphasizing now that the central bank still has much work to do in terms of raising interest rates to restore inflation control. At the same time, she has indicated that in March, the ECB will begin a process of quantitative tightening at a monthly pace of 15 billion euros ($16 billion).
Italy’s public finances were in a poor state even before the ECB’s latest tightening move. At close to 150% of gross domestic product, the country’s public debt was considerably higher than it was at the height of the 2012 Italian sovereign debt crisis. Meanwhile, with a budget deficit of more than 5% of GDP and a sclerotic economy, there is little prospect that the country can grow itself out from under its debt burden within the straitjacket of the euro.
The ECB’s shift to a more-hawkish monetary policy stance now threatens to complicate Italy’s already precarious public finances. It does so by raising the Italian government’s borrowing costs and by heightening the risk of a meaningful Italian economic recession. Italian 10-year government bond yields have risen from a little over 1% at the start of the year to around 4.5% at present. The ECB’s quantitative-tightening program will not begin until March.
Next year, the Italian government has an estimated gross borrowing need of 250 billion euros ($266 billion). This has to raise a basic question. With the ECB now in the process of shifting from a policy of massive quantitative easing to one of modest quantitative tightening, who will cover the Italian government’s large financing needs?
To be sure, in the event that Italian bond spreads do widen abruptly on market fears about Italian public debt sustainability, the ECB could activate its newly announced Transmission Protection Instrument to bail Italy out again. However, it would be awkward for the ECB to start printing money again at a time it is supposed to be engaged in monetary policy tightening to regain inflation control.
Use of the Transmission Protection Instrument is also likely to raise acute political tensions between the Italian and German governments as to the conditions to be attached to any new Italian ECB lending. The Italian government is likely to bridle at any thought of loan conditions. Meanwhile, the German government will balk at lending freely to a country with Italy’s poor record of public-finance management without conditions to put the country’s public finances on a sounder footing.
What all of this might mean for the euro’s longer-run survivability is difficult to say. However, what seems clear is that Italy’s shaky public finances are all too likely to constitute yet another source of financial-market instability next year at a time of rising global interest rates.
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