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Italy’s Looming Fiscal Crisis

Italy’s Looming Fiscal Crisis

The only reason Italy hasn't defaulted on its debt yet is the ECB's favorable borrowing terms. And as painful defaults are, they are necessary for the economy.

Normally, I tell people to focus on government spending rather than red ink. After all, the economy is hurt whether spending is financed by taxes or borrowing (or printing money).

But I’ve also noted that governments sometimes spend so much money and incur so much debt that investors decide it is very risky to buy or hold debt from those governments. In other words, they begin to fear default.

When investors (sometimes known as “bond vigilantes”) reach that stage, they probably try to get rid of their holdings and definitely refuse to buy more debt. The net result is that profligate governments have to offer much higher interest rates to compensate for the risk of a possible default.

That happened earlier this century in Greece.

And if peruse this data from the OECD, you find that Italian government debt has jumped to levels that may be unsustainable.

So why has Italy avoided a crisis?

As noted in this article by Desmond Lachman, published by Inside Sources, the nation is being propped up by the European Central Bank.

In Europe, when the European Central Bank (ECB) soon dials back its bond-buying program, we are likely to find out that it is the Italian economy that has been swimming naked. This should be of deep concern for the Eurozone and world economies. While the Italian economy might be too large for its Eurozone partners to allow it to fail, it also might prove to be too large for them to bail it out. …The main factor that has allowed the Italian government to finance its ballooning budget deficit on favorable terms has been the ECB’s massive government bond-buying…the ECB used its emergency bond-buying program to more than fully finance the Italian government’s borrowing needs. …it must be only a matter of time before we have another round of the Italian sovereign debt crisis. …no longer being able to count on ECB bond-buying, the Italian government will have to increasingly finance itself in the market. It will have to do so with its public finances in a worse state than they were in during the 2012 debt crisis.

In the article, Lachman thinks a crisis is all but inevitable because the ECB is unwinding its pandemic-era money creation. I agree about the ECB’s harmful role, but I fear the central bankers in Frankfurt will continue to do the wrong thing. Italy can solve its problems, but I doubt it will choose the only effective solution.

Let’s start with this chart, which shows debt levels in Portugal, Italy, Greece, and Spain (the so-called PIGS) ever since the misguided bailout of Greece about a dozen years ago. As you can see, OECD data reveals that there’s been no change in these poorly governed nations. They have continued to over-spend and accumulate ever-higher levels of debt.

Let’s start with this chart, which shows debt levels in Portugal, Italy, Greece, and Spain (the so-called PIGS) ever since the misguided bailout of Greece about a dozen years ago. As you can see, OECD data reveals that there’s been no change in these poorly governed nations. They have continued to over-spend and accumulate ever-higher levels of debt.

Source: OECD

This certainly seems like evidence of failure, in part because of Greece’s continued bad policy. But I’m equally concerned about how other Mediterranean nations did not change their behavior. So why did those nations accumulate more debt, even though they had an up-close look at Greece’s fiscal collapse? I suspect they figured they could get bailouts, just like Greece. In other words, the IMF and others created a system corrupted by moral hazard.

Defenders of bailouts assert that Greece was forced to engage in “austerity” as a condition of getting a bailout. I have two problems with that argument.

First, notice how Greece’s debt has continued to go up. If that’s a success, I would hate to see an example of failure.

Second, the main effect of the so-called austerity is a much higher tax burden and a somewhat higher spending burden.

If there’s a bailout of Italy (or any other nation), I suspect we’ll see the same thing happen. Higher taxes, higher spending, and higher debt.

I’ll close by acknowledging that there are costs to my approach. If Italy is not given a bailout, the country may have a “disorderly default,” meaning the government simply stops honoring its commitments to pay bondholders. That is bad for individual bondholders, but it also could hurt – or even bankrupt – financial institutions that foolishly decided to buy a lot of Italian government bonds. But there should be consequences for imprudent choices. Especially if the alternative is bailouts that misallocate global capital and encourage further bad behavior. The bottom line is that the long-run damage of bailouts is much greater than the long-run damage of defaults.

Author

The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.

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