It would be a gross understatement to say that all is not well with the Italian economy. This should be of the greatest concern for European policymakers, since a struggling Italian economy must throw into question the Euro's long-run viability.
Unlike Greece or Portugal, Italy has a large economy with an out-sized public sector debt level that now exceeds $2 trillion. Its large banking sector is in trouble. In the event of a renewed economic recession, this would make Italy too big for the European Central Bank to save. And without Italy, the Eurozone’s third largest economy, it is difficult to see how the Euro can survive in its present form.
A measure of how troubled is the Italian economy is its weak economic performance since the 2008-2009 Great Economic Recession. That weak economic performance has included another three-year economic recession between 2012 and 2014, which only ended last year when the Italian economy rebounded by a mere 0.8 percent. As a result, whereas the United States economy is now some 10 percent above its pre-2008 economic peak, the Italian economy remains some 6 percent below its pre-2008 peak.
Italy’s lackluster economic performance over the past two years is all the more troubling considering how favorable has been its external economic environment. International oil prices have fallen by more than 60 percent, the European Central Bank has driven interest rates down to historically low levels, and a weak Euro has helped improve Italian export competitiveness.
Yet, despite all these favorable tailwinds, the International Monetary Fund is forecasting that the Italian economy will grow by only one percent in 2016. This has to beg the question as to what might happen to the Italian economy should external conditions no longer be as favorable as they are today, or should the global economy be hit by the realization of any of the many serious risks it is now facing.
The weak Italian economic recovery, coupled with its tendency towards outright price deflation, has made it difficult for Italy to make any progress in reducing its public debt to a more sustainable level. Indeed, while in 2008 Italy’s public debt to GDP ratio was around 105 percent, by 2015 that ratio had risen to over 130 percent. After Greece, Italy has the highest public debt to GDP ratio in Europe. Disturbingly, it has continued to rely heavily on its domestic banking system to prop up its public debt market.
An equally troubling aspect of the Italian economy is the shaky state of its banking system. This is most apparent in the high level of the banking system’s non-performing loans, which have been boosted by two successive and protracted domestic economic recessions. In Europe non-performing loans are on average around 6 percent of total bank loans, but in Italy that ratio has risen to as high as 17 percent.
Further indications of trouble in the Italian banking sector are the 40 percent decline in Italian bank shares since the start of the year and the need for the Italian government to cobble together a privately funded bank bailout scheme. The program, dubbed Atlas, helps support the weaker small lenders in the Italian banking system.
If Italy’s economy should be a concern for European policymakers, so too should its politics. Support for Prime Minister Matteo Renzi’s government has halved over the past two years, largely in reflection of the electorate’s disappointment over his failure to jump-start the economic recovery. More troubling yet is the growing anti-European sentiment that lackluster economic growth is fomenting across the Italian political spectrum, with the notable exception of within Mr. Renzi’s Democratic Party.
At a time that Europe faces the real risk of a Brexit or a Grexit, the last thing that it needs is financial market turbulence in Italy. This should spur the European Central Bank to redouble its efforts at promoting overall European economic growth and at minimizing the risk of European deflation. It should also induce the European Commission to give the Italian government some slack to allow it to use budget policy more actively to get the Italian economy moving again.
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.