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Angela Merkel’s Italian Nightmare

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By Desmond Lachman

Anyone who doubts that the euro crisis is soon to enter a new and more serious phase is simply not paying attention to Italian politics. After a fractious election, which favored comedian Bepe Grillo’s populist Five-Star movement, it took the Italian president more than two months to cobble together the weakest of coalition governments. And last week, in his maiden speech to parliament, Enrico Letta, Italy’s new prime minister, vowed to pursue policies that would end European-imposed austerity.

In taking pains to emphasize that austerity has been killing the Italian economy, Mr. Letto has put his country on a collision course with Mrs. Merkel, the German Chancellor. It would be a gross understatement to say that Germany has a very different take than Italy on the relative merits of fiscal rectitude. This is all too likely to raise acute political tensions within the euro area later on this year when markets again focus on Italy’s very large public debt problem.

Mr. Letta’s fulminations against austerity reflect deep-seated Italian public discontent with the dismal results of the restrictive economic policies pursued at the behest of Italy’s European partners by Mr. Monti, his technocratic predecessor. During Mr. Monti’s year in office, the Italian economy contracted by 2-½ percent, while Italian unemployment rose to a record level of almost 11 percent. As a result, the Italian economy is now a staggering 8 percent smaller than it was before the 2008 global economic crisis began.

With the Italian economy in a virtual state of economic depression and with seemingly no light at the end of the austerity tunnel, it is little wonder that Mr. Monti’s party was trounced at the polls in the February 2013 elections. Nor is it surprising that more than 60 percent of the Italian electorate voted for candidates who openly campaigned against the continued pursuit of austerity.

With new Italian elections all too likely before year-end, Mr. Letta has lost no time in joining Bepe Grillo and Silvio Berlusconi on Italy’s anti-austerity bandwagon. He has done so by announcing plans to cut taxes for homeowners, consumers, and companies by more than EUR 10 billion, or around half a percent of GDP. And he has done so despite Italy’s burdensomely high public debt level.

An Italian move away from austerity at this stage poses real risks to Italy’s public finances. According to estimates of the Organization for Economic Cooperation and Development (OECD), even without an easing in Italian budget policy, Italy’s public debt to GDP ratio is set to rise from 127 percent in 2012 to 134 percent by 2014, or to levels that typically raise serious questions about debt sustainability. It also must be of concern that these debt projections could be boosted by the considerable downside risk to Italy’s economic outlook posed by the country’s current state of political instability as well as by Mr. Letta’s apparent largesse with Italy’s public revenues.

Buoyed by ample money printing by the Federal Reserve and by the Bank of Japan, global markets are currently turning a blind eye to Italy’s deteriorating political and economic fundamentals. However, experience would suggest that once the money printing music stops, countries with weak public finances like Italy’s will pay a very heavy price for their lack of budgetary discipline. At times like those, markets will also soon grasp that the European Central Bank cannot backstop an Italy that has turned its back on fiscal austerity and that is unwilling to negotiate an economic adjustment program with its European partners.

An Italian economic and financial crisis would have a much greater impact on Europe than any similar such crisis in Cyprus, Greece, Ireland, or Portugal. After all Italy is the euro area’s third largest economy. And with a public debt of around EUR 2 trillion, it is the world’s third largest sovereign debt market.

Whereas one could imagine the euro surviving a Cypriot, Greek, or Portuguese exit, one simply cannot envisage the euro surviving an Italian exit. This gives the Italian government ample leverage in its negotiations with Germany for an easing in the budget austerity that Brussels might demand of it. However, it also sets up the risk of a fatal Italian miscalculation in the sense that the Italian government might be tempted to push the Germans beyond the point to which they could go politically on the budget austerity issue.

If nothing else, the risk of a major Italian economic crisis down the road should be at the forefront of policymakers’ minds in Berlin and Frankfurt. At a minimum, one would hope that German officials adopt a more accommodative policy stance and that the ECB does more to jumpstart bank lending in the European periphery to get those economies growing again. Since without a better external environment, Italy’s day of reckoning cannot be too far away.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.