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Italexit Would Make Brexit Look Like a Picnic

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Italexit Would Make Brexit Look Like a Picnic

December 2, 2016

Europe has seemingly coped well with its recent Brexit shock, but now looms the prospect that Italy might be heading for the Eurozone’s door. This should be of great concern to European and global economic policymakers. While it is possible to think of a Europe without the United Kingdom, it is difficult to conceive that the Euro in anything like its present form could possibly survive the departure of Italy, the Eurozone’s third largest member country. It is also difficult to imagine that the Euro’s unraveling would not be a globally systemic economic event.

The prospect that Italy could be on the way out of the Euro within a year or two is far from fanciful. After all, Italy’s economic performance within the Euro has been nothing short of dismal. Eight years after the 2008-2009 Great Economic Recession, the Italian economy is still some 6 percent below its pre-2008 peak and its unemployment rate remains stuck at above 11 percent. Equally concerning is the International Monetary Fund’s projection that a sclerotic Italian economy will only regain its 2008 output level in 2025. 

The political fallout from years of highly disappointing Italian economic performance is soon to be tested at the polls. This Sunday (December 4), Italy is scheduled to hold a referendum on constitutional reform, mainly involving a proposed streamlining of its two-chamber parliament. With Prime Minister Matteo Renzi committed to resigning should he lose the referendum, the opposition has converted this referendum into a vote of no- confidence on the government.

A prolonged period of political uncertainty is the last thing that a sclerotic Italian economy now needs. Its banking system is burdened with non-performing loans that amount to around 18 percent of its outstanding loans, and its public sector debt has risen to 135 percent of GDP.

Yet, in the event that Mr. Renzi were to lose the referendum, political uncertainty is precisely what Italy would get. It is very possible that new parliamentary elections would need to be called. At a minimum a no vote in the referendum would embolden the country’s populist Five Star Party, which is already level with Mr. Renzi’s Democratic Party in the polls and which is committed to taking Italy out of the Euro. This would hardly instill confidence in either Italy’s bank depositors or its public debt holders.

The reason that European policymakers should fear a period of prolonged Italian political uncertainty is not simply that the Italian economy is already very weak and that its banks are on the cusp of a full blown crisis. Rather it is that, unlike the case in Greece, Ireland, and Portugal, Italy is simply too large to be saved through loans from the European Monetary System or through bond buying by the European Central Bank.

Italy is too large to save partly because it is presently the world’s third largest government bond market, with more than 2 trillion euros in outstanding government debt. Furthermore, Italy’s banks have assets totaling more than 4 trillion euros and around 360 billion euros in non-performing loans. These figures dwarf by a multiple the corresponding figures for other countries in the European economic periphery.

Italy may be lucky and Mr. Renzi may somehow win the referendum. If that were to occur, one must hope that he will take advantage of the window of political stability that such an outcome might afford him. He could use it to press ahead with the deep structural economic reforms that have been so wanting to date and that are so necessary to get the Italian economy moving again. Without economic growth, there is little hope that Italy can either restore its banking system to health or fully service its public debt mountain.

A version of this column originally appeared on Economics21 on August 21, 2016.

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.

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