By: Andrea Ferrell

Europe’s third largest economy just entered into a recession.  What may this contraction mean for the rest of Europe?

At the end of 2018, Italy entered into its third recession in the past ten years while a new government made up of the Five Star Movement and the League parties took power. The Italian economy, dominated by the import/export of machines, is still reeling from the European debt crisis in 2012 while the new government, intentionally or not, has accelerated the contraction of Italy’s shrinking manufacturing sector and increased political gridlock. To see how Italy got here, let’s explore its past economic woes.

The European debt crisis began on the heels of the financial crisis of 2008 when fringe countries of the European Union (Greece, Spain, Portugal, Ireland and Cyprus) were unable to pay their debt without the help of a third party, mainly the International Monetary Fund (IMF) or the European Central Bank (ECB). In addition to the 2008 financial crisis, the debt crisis was also rooted in a housing/property bubble in many European countries. During the crisis, rating agencies downgraded debt from Portugal, Greece and Ireland to junk status, sovereign bond yield peaked, and high interest rates continued to spook investors. In 2011, the yield on the Italian 10 year bond was 7.19% and interest rates reached a high of around 7%. In order to deal with the crisis, the ECB and IMF bailed out out Greece and dropped interest rates to near zero. It has been more ten years since the crisis began, and the ECB’s interest rates continue to stay at zero as Europe deals with the effects of the debt crisis. At the end of 2018, manufacturing confidence was down as investors began to worry about the negative effects of trade wars on the productivity of European countries.

While Italy did not default on their debt during the crisis, many investors worried about the Southern-European country. Since the 1990s, Italy has had high debt. In 2007 their debt-to-GDP ratio, which measures how well a country can pay back their debt, was 103.1%. The financial crisis of 2008 lead to major liquidity problems as the uncertainty around borrowers lead to a reduction of credit and a decrease in consumption, which crippled the already weak economy. During the debt crisis, Italy’s problems lay in their public debt, and so it used capital markets to raise funds, whereas other European countries used the ECB for bailouts. Italy’s high debt only became a problem in the context of other European countries defaulting on their debt because investors began to “lose confidence in the ability of the Italian state to service its debt.” The 2018 election did not help improve the future outlook for Italy.  The newly elected Italian government was one of gridlock as the lower house was dominated by the center-left and the majority of the upper house was  center-right.

The Frustrations of the Italian people came to a head in the 2018 elections when a new populist coalition was formed by the Five Star Movement and the League. These two “parties” focused on the ordinary Italian and are working to increase government spending to improve overall quality of life. This political change is rooted in economic inequality (seen in high youth unemployment), a frustration with government corruption and high immigration. One factor that holds these two parties together is a resistance to the European Union. It took this new coalition almost nine months to agree on an Italian budget with the European Union, where many of the populist goals were cut out of government spending. This coalition has been in power for less than a year, but there have already been negative effects on the economy.

A recession is  defined as two consecutive periods of contraction, and Italy fits this rule as GDP growth was -0.1% and -0.2% in the third and fourth quarter of 2018, respectively. Prior to the 2018 elections, Italy’s economy was stagnant, but since the coalition came to power the European Commission has cut Italy’s GDP growth projections from 1% to 0.6%. What has caused this slowdown in Italy? The populist government continues to swell the government budget even though there has been little change in consumption. Manufacturing contracted 2.5% and 5.5% in November and December of 2018, respectively. Likewise, the coalition continues to break European Union rules of fiscal discipline. As a result of these factors, the Italian economy entered into a recession at the end of 2018.

Italy is Europe’s third largest economy, so the possibility of a debt default could have detrimental effects on the European economy. Many European banks hold Italian bonds, and an increase in Italian sovereign bond yields would make government payments harder to fulfill. Likewise, the ECB would be unable to bailout Italy’s $2 trillion economy, which would force Italy into deeper problems. Overall, European growth is slowing, as seen in Germany’s slowing car sales and threats from Brexit, adding more pressure to Italy’s ability to grow. While uncertainty around debt payments continue to plague Italy, investors are still buying sovereign debt, stating that the 2.785% yield on the Italian ten-year is higher than any other yield on other European sovereign debt (for context, the yield on Germany’s ten-year bond is 0.1%).

How can Italy deal with its debt problem? More immigration would help alleviate such high youth unemployment, but increasing quotas would be almost impossible in a government lead by an anti-immigrant party. Similarly, Italian banks have slowed their lending to citizens, which has hurt production and growth in the country. An increase in bank loans could also help jumpstart consumer spending as people and businesses would have more money to build infrastructure and spend within the Italian economy.

For decades the Italian government has been heavily debt ridden, and the future seems to be no exception. Italy’s future growth is reliant on its ability to jumpstart consumption and the overall trajectory of European growth, which seems to be slowing.

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Image source: https://www.japantimes.co.jp/opinion/2015/01/12/commentary/world-commentary/europes-unending-crisis/#.XHBhwi2ZMb0

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