The Awkward Truth of Italy’s Relationship with the European Central Bank

Leslie Lipschitz writes:
July 8, 2022 1:23 pm ET
The European Central Bank has undertaken to tighten financial conditions to reduce inflation. In doing so it faces a conundrum, one that markets already anticipate. Tighter monetary policy may increase the interest rate spread on Italian government borrowing and thereby precipitate a financial crisis for Italian sovereign debt. Italy’s sovereign debt market bulks large within the euro area, so an Italian sovereign debt crisis would threaten the integrity of the currency area as a whole.

The ECB, therefore, intends to announce new mechanisms to prevent so-called financial fragmentation at its policy meeting this month. Because of the perceived urgency of avoiding a financial crisis, policy makers and commentators generally assume that such fragmentation—that is, a greater dispersion of risk premiums on government bonds across euro-area countries—is a bad thing. It is also assumed in much of the writing on the issue, that even with a tightening of financial conditions, the problem can be solved by adding some new financial instrument to the ECB’s policy toolbox. The situation and the assumptions raise three questions.

What is the immediate risk of financial crisis?

The most pressing problem relates to the financial sustainability of Italy’s sovereign debt. Italy’s debt amounts to about 150% of its gross domestic product. Economists and investors would probably regard this as sustainable if the debt ratio was seen to be on a downward trend. But if it were projected to rise inexorably a vicious circle of detrimental developments would ensue.

The mechanisms are important to understand.

The path of the debt-to-GDP ratio depends on three variables: It rises with a higher interest rate on the debt and a wider primary deficit (that is, the deficit excluding spending on interest), and it falls with a higher rate of growth of nominal GDP. As long as the interest rate on the debt is low—that is, the spread in relation to the near-zero rate on German debt is small—it will be easier to achieve sustainable fiscal finances (and to convince markets of this). The relevant interest rate is the average rate on government debt, which will be below the current rate to the extent that longer-term debt at low rates is still on the books. However, over the next year Italy will probably have to refinance maturing debt and roll over short-term paper together equivalent to about 32% of GDP, a sizable financing requirement. So the ECB will be keen to contain the interest rate on this new borrowing.

The other two relevant variables—nominal GDP growth and the primary budget balance—may not provide much comfort. Italy was in primary surplus going into the pandemic but then recorded a substantial primary deficit in 2020. The primary balance was still equivalent to minus 3.8% of GDP in 2021 and it is projected to remain negative over the next few years. Membership in the euro area reduced the interest component of the deficit, but the overall deficit is still high. Real growth will likely be subdued this year and next, but nominal growth may be boosted by inflation if this is domestically generated rather than imported.
What is most frightening, however, is that the basic arithmetic of fiscal sustainability is highly sensitive to market risk premiums. If investors believe that Italy’s government debt situation is unsustainable and that there is some risk of their being forced into a debt restructuring, the risk premium and thus the interest rate on new Italian borrowing will increase, exacerbating the problematic debt dynamics, and leading to a self-fulfilling spiral—the so-called doom loop. Even a small probability of such an outcome would constitute an emergency for the ECB and euro-area governments. This is the nightmare that the ECB faces as it seeks to contain inflation by raising interest rates and ending quantitative easing.

What can the ECB do?

The ECB has promised to explain what instruments it proposes to use to contain the spread on Italian debt (and that on other fiscally-fragile euro-area countries). It has already indicated that it will reinvest maturing government debt acquired under its Pandemic Emergency Purchase Programme flexibly—presumably shifting into the government debt of those countries with the most fragile fiscal finances. This, by itself, will likely be insufficient to alter market perceptions of risk. The ECB could also deploy its Outright Monetary Transactions program to buy debt of countries facing financial crises. There are problems with employing this instrument, however. It acknowledges that there is a crisis; it is supposed to be used only in circumstances where the problem is one of liquidity (rather than fundamental unsustainability) and is thus amenable to corrective policies; and it is set up to be contingent on significant policy reforms (a condition that will almost certainly prove politically unpalatable in Italy).

All of this presages an extraordinary ECB meeting, scheduled to begin July 21. The ECB will seek to announce measures that are sufficiently contractionary to bring down inflation without exacerbating the growth- inflation- and interest rate-sensitive debt dynamics of countries with fragile fiscal financing. The efficacy of these measures needs to be convincing to markets. And the measures have to be agreeable to the more austere northern countries that have sought to contain the spread of the ECB’s mandate into fiscal support.

Is the ECB really capable of fixing the problem?

The ECB may be able to craft a strategy that achieves the immediate objective of quelling market fears of an Italian debt crisis while still withdrawing stimulus to reduce inflation. The term financial fragmentation implies that a dispersion of market risk premiums is something to be avoided, but, over the longer run, it is not at all clear that a suppression of these premiums—that is, an intervention to influence the market’s pricing of risk—is a good thing. Certainly, if high risk premiums were a market failure, based on unrealistic or ill-informed expectations that differed from the sound judgments of the ECB, bold corrective policies would make sense even in the longer run. But it would be a stretch to argue along these lines.

The fundamental problems that Italy faces are in the real economy and the fiscal system. Financial markets merely reflect these facts.

Three sets of data make the case:

First, the international competitiveness of Italian production, measured in terms of GDP deflators, has been poor compared with that of Germany and other strong performers, although it has improved somewhat more recently.

Second, Italy’s average worker productivity—output per person employed—was higher than that of Germany and the euro-area average until about a decade ago, but it has fallen sharply against these comparators since then. The fall in total factor productivity—which measures the overall output of an economy relative to its inputs—has been even more accentuated.

Finally, these developments, together with the very low and flat share of the population in employment, explain the stagnation of living standards. Real GDP per capita in Italy in 2021 was 1% higher than in 1999 while that in Germany rose by 25% over the same period.

The data suggest that the low rates of interest across the euro area—the opposite of financial fragmentation—have encouraged investments in Italy that might not have occurred at more elevated rates, and that the overall return on capital has fallen below that in other euro-area countries. Clearly there are fundamental institutional or structural impediments in Italy that are holding down growth and exacerbating fiscal and financial difficulties.

The bottom line is this: Risk premiums, though capricious in tending to overshoot underlying conditions at times, are real variables rooted in an assessment based on economic fundamentals. The financial tools available to the ECB can, at best, reduce the volatility of these premiums and win time for reforms, but they cannot stifle them indefinitely. Any attempt to do so—one recalls former ECB President Mario Draghi’s promise to “do whatever it takes”—would require unlimited purchases of the debt of fragile countries and an ever-expanding balance sheet.
Courtesy: Barron’s