Italy may be the source of fine wine, great pizza and creamy gelato, but it has been one of the most poorly run countries in Europe for decades. Italy’s high debt levels, political dramas, rules and policies, and government turnover are not only inhibiting its ability to grow but also setting the stage for Europe’s next big crisis.
The media is understandably enjoying the ability to exploit another crisis. The UK’s Mirror recently wrote,
“The third largest economy in the eurozone is teetering on the edge of a political and financial catastrophe which has caused panic in Brussels and sent jitters through the world markets. At stake is not just the welfare of millions of Italians but the future of the single currency and even the EU itself.”
Effective fearmongering must contain a kernel of truth, and, sadly, Italy’s behavior provides that. The recent drama has been the result of the increasing popularity of two populist parties, the 5 Star Movement and the League, who have emerged as powerful parties. Both parties have extensive plans to dramatically increase spending and both are considered anti E.U., known as eurosceptics. The politics in Italy has been a mess for years and today is no different. Indeed, there are about about 15 active political parties and since the end of World War II Italy has had nearly 70 governments –almost one per year, and more than any other European country. The U.S. is only on its 45th President over nearly 250 years. This constant political turnover and lack of continuity has made running Italy well an impossible task, something borne out by the economic results.
Not surprisingly Italy’s debt profile might be as poor as its political one. The country’s debt as a percentage of GDP at 130% is already the third highest in the world, behind only Greece and Japan. On a per capita basis Italy’s debt is worse than Greece. By increasing spending sharply, Italy’s already bloated budget could worsen significantly under the populist leaders, which would also put it at odds with requirements for remaining within the EU. If this isn’t problematic enough, economically speaking, Italy is almost 10 times the size of Greece and is the 9th largest economy in the world (Greece is about the 53rd largest). So the threat from Italy, if it has problems, is far larger than the significant global turmoil that we saw stemming from Greece.
The opportunity for contagion around Europe, and by extension the world, from a crisis in Italy is real. Italy could certainly end up leaving the E.U. A surge in Italian interest rates would certainly disrupt credit markets across Europe, as we glimpsed this past week. All of this would likely drive significant global market volatility even if cooler heads eventually prevail.
If Italy does move ahead with large spending increases and some form of crisis ensues, the economic impact on the U.S. economy would likely be limited. U.S. GDP is largely driven from within despite the amount of global trade that now occurs. Exports only make up about 13% of U.S. GDP and Italy accounts for just 1% of exports. Even the E.U. as a whole only comprises about 19% of U.S. exports. And while there would be some contagion risk to some of the banks, the overall economic impact would not be large. Even so, market reactions could be quite dramatic. Our markets were badly disrupted and equities declined sharply when Greece melted down, yet Greece’s economy is quite small and our exposure was very limited. Italy is 10 times larger, so our markets would be likely to react strongly, even though the economic effects would remain fairly modest.
All of this assumes that the populist parties in Italy would indeed make the fiscal changes that would increase debt levels and keep those debt levels elevated. With political change an annual Italian tradition, debt-based spending may not last. Attempts to leave the E.U. may also prove to be overblown. Among European countries Italians have the least public support for remaining in the E.U., but still a sizeable majority of the public wants to remain. Neither the fiscal spending increase nor leaving the E.U. may happen and Italy’s politicians are hopefully engaging in rhetoric. Nonetheless, given the sharply heightened risk from the 9th largest economy in the world and an economy that is already fragile, caution is warranted. Just not with the gelato.