E The Basic Flaw In The EU Fiscal Position: The Case Of Italy Today

Having survived the 2012 EU debt crisis, bond traders are now focussed on the looming crisis in Italy as that country’s government is prepared to run large fiscal deficits. There are mounting fears for the country’s financial well-being, and, more importantly, for the potential spill-over effects onto its European neighbors.

At the heart of this issue is Italy’s new populist government’s intention to increase the level of public debt which already stands at 130 percent of GDP. Italy’s ruling coalition yesterday decided to boost the country’s 2019 deficit to 2.4% of GDP, compared to Brussel’s demand for a deficit no greater than 2.0%. The bond market immediately punished the Rome government today as the 10yr Italian bond soared by 36pbs.

We witnessed similar developments in the 2012 crisis, especially in Greece when that government lost control over its fiscal policy. The Italian crisis is a prime example of the basic flaw in the European Monetary Union (EMU). The European Central Bank runs monetary policy, but individual countries run their own fiscal policy. When individual nations joined the EMU, they essentially adopted a foreign currency—the euro—but kept the responsibility for their own fiscal policy. There is simply no central governmental authority within the EU to manage and coordinate fiscal and monetary policies as exists in the U.S., U.K, Australia or Canada.

Italy continues to experience low growth and high unemployment. As political pressures build, it is inevitable that budgets will run deep into the red. Consequently, financial markets will tack on a higher risk premium on sovereign debt and that is precisely what we are seeing today. Unlike Greece, the majority of Italian debt is held domestically, however, that puts great pressure on the Italian banking system. The Italian bank shares index fell as much as 5% today. At this moment, it is not clear how much of this current Italian debt crisis will spread to other financial markets in neighboring countries.  Nonetheless, the EU members are very concerned that these soaring debt yields do not result in a repeat of the 2012 crisis. After all, the Italian economy is nearly ten times larger than that of Greece and we recall how much havoc the Greek fiscal crisis caused the EU members.