The euro crisis appears to have moved on. If the newspapers are to be believed, a crisis once centred on Greece has now crossed the Adriatic to Italy.
The Economist recently ran with a leader article entitled The Italian Job, which argued that “at best Italy’s weak banks will throttle the country’s growth; at worst, some will go bust”.
Ambrose Evans-Pritchard, writing in The Daily Telegraph, said that Italy leaving the euro “may be the only way to avert a catastrophic deindustrialisation of the country before it is too late”.
If that wasn’t bad enough, Wolfgang Munchau, writing in The Financial Times, went much further: “An Italian exit from the single currency would trigger the total collapse of the Eurozone within a very short period. It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash.”
The phrase “be afraid, be very afraid” springs to mind. And yet financial markets don’t appear to be afraid at all. The share prices of Italian banks have plummeted this year, but there does not appear to be any fear of systemic risk.
At the time of writing, Italian and Spanish 10-year bonds were trading at 1.24 per cent. The annual probability of default, based on five-year sovereign credit default swap spreads, is around 2 per cent for Italy and 1.5 per cent for Spain.
Crisis? What crisis? How do we reconcile these numbers with the words “most violent economic shock in history”?
Fears that the EU would rigidly apply the new bail-in rules on Italian banks, based on comments by Chancellor Merkel and the Dutch finance minister, largely explain the Armageddon quotes. The concern was that no bail-out of Italian banks would lead to bank failures, and a spike in Italian government bond yields, as the so-called doom-loop of sovereign-bank failure took hold. However, it is clear that a loop-hole exists, whereby a state bailout of Italian banks can occur, without a politically suicidal bail-in of individual Italian investors.
Post-Brexit, EU leaders will also want to avoid yet another political crisis.
In recent years the European Central Bank’s (ECB) policy stance has shifted decisively with the introduction of Outright Monetary Transactions (OMT, albeit conditional) and Quantitative Easing (QE, now at €80bn per month). The ECB has a big bazooka and it is prepared to use it.
Even if Brussels and Berlin were to be intransigent over the bail-in rules, the Italian government could still go it alone, bailing out the banks regardless of EU rules, on the basis that “it is easier to ask forgiveness, than permission”.
But while these arguments appear solid, they provide no grounds for complacency.
The current political situation in Italy is fluid, with the rise of the Eurosceptic Five Star Movement and a referendum on constitutional reform in October. This could yet lead to a change of government and a referendum on the euro. Moreover, even though I expect the euro to avoid a crisis in the short term, two factors lead me to believe that Italy could trigger a resumption of the euro crisis in the long term.
First, nominal GDP in Italy is around 25 per cent below trend. When nominal GDP is this far below trend, banking sector difficulties are almost a given. Second, the Italian economy is facing not one, but two decades of lost GDP growth. Throw in demographic decline and Italy could even face three decades of lost GDP growth. Economic failure on such a scale will raise fundamental challenges to existing political and economic institutions.