Two long-term trends make me worry about the Italian economy, regardless of the outcome of the referendum this weekend. First, the so-called Italian Death Cross, and second the prospect of three decades of lost growth (yes three, this isn’t a typo).
In my view, these two trends make Italy’s exit from the euro almost inevitable at some stage. This is not if, but when. Italian 10-year treasury bonds are yielding 2 per cent, up from 1 per cent in the autumn, and other vital signs, such as the scale of current account and fiscal imbalances, are also very different from the onset of the Greek crisis. But while this provides some comfort, look elsewhere and there is much to fear.
Nominal GDP in Italy is around 25 per cent below trend. This has given rise to the so-called Italian Death Cross chart, with nominal GDP relative to trend falling, and bad debt rising. When nominal GDP is this far below trend, banking sector difficulties are almost a given.
The stop problem (of international capital flows which came to an abrupt end), which triggered the original Greek crisis, has been replaced by a slow problem (of rising non-performing loans) in Italy. Unsurprisingly, research shows that an economy predisposed to grow slowly will experience a more virulent interaction between financial sector shocks and public debt.
Non-performing loans (NPLs) in Greece rose from 14 per cent of total loans in 2011 to 35 per cent in 2015. NPLs in Cyprus increased from 18 per cent in 2012 to 46 per cent in 2015. If the NPL ratio in Italy is 18 per cent before any crisis, where might it be in the event of a crisis? Because of the size of the Italian economy, banking sector difficulties would have major systemic implications for the entire Eurozone.
My second concern relates to lost growth. The Italian economy is already in its second decade of lost growth. Throw in demographic decline in the 2020s and it is reasonable to argue that Italy could face three decades of lost GDP growth.
Economic failure on such a scale will raise fundamental challenges to political and economic institutions. The continued deindustrialisation and hollowing out of the Italian economy will, rightly or wrongly, be blamed on the euro. Arguments over price versus non-price competitiveness are likely to receive a tin ear, as politicians yearn for the “good old days” of lira devaluations. Italy leaving the euro may be the only way to avert a catastrophic deindustrialisation of the country.
But just when you thought that was bad enough, one economic commentator foresees even darker days ahead. Wolfgang Munchau, writing in The Financial Times, says: “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.”
It’s not difficult to see how worst case scenarios could play out. Market uncertainty would be fuelled by contagion fears, the solvency of Italian banks and the so-called sovereign-bank doom-loop. Throw in a potential change of government (and higher probability of exiting the euro) and there would need to be massive intervention by the ECB.
Financial markets aren’t signaling anything like this scale of problem. Let’s hope they’re right.