Warren Buffet famously said that only when the tide goes
out, do you discover who has been swimming naked.

In Europe, the tide of very easy money is about to go out at
the very time that the Italian economy has been swimming naked. This could
constitute a major problem for the global economy which is in no position to
weather a sovereign debt crisis in a country as systemically important as
Italy.

With European inflation now running at a record 7.5 percent, the European Central Bank (ECB) is signaling that soon it will be turning off its monetary policy spigot to fight the inflation beast. Over the past two years, that spigot has flooded the European economy with around $4 trillion in liquidity through an unprecedented pace of government bond buying.

The end to ECB money printing could come as a particular
shock to the Italian economy, which has grown accustomed to having the ECB
scoop up all of its government’s debt issuance as part of its Pandemic
Emergency Purchase Program. That has allowed the Italian government to finance
itself at record-low interest rates despite its very weak economy and its very
poor public finances.

With the ECB’s music of easy money about to end, the Italian
government finds itself in dire straits. Not only did Italy find itself at the
center of Europe’s COVID-pandemic. It also was particularly exposed to the
Russian energy price shock with as much as 40 percent of Italy’s natural gas
needs being supplied by Russia.

As a result of both the pandemic and the Russian energy
price shock, the country’s economy has stalled, its budget deficit has
ballooned, and its public debt has skyrocketed to 150 percent of GDP. That debt
level is higher than it was after each of the last century’s two world wars.

The ECB’s imminent shift to a more restrictive monetary
policy stance is likely to further compromise Italy’s public finances. This is
not only because the European economy might succumb to another recession as the
ECB is forced to fight inflation. It is because the Italian government’s
borrowing costs might rise both because of higher ECB interest rates and the
higher risk premium that investors will now require on Italian bonds.

Now that the ECB will soon no longer be buying Italian
government bonds, if Italy is to avoid a debt crisis it will need to assure
both foreign and domestic investors that it will bring down its debt level to a
more reasonable level. However, stuck in a Euro straitjacket, Italy will find
that to be no easy task.

Being stuck in the Euro, Italy can no longer resort to
currency depreciation as an offset to the negative effects on aggregate demand
of budget belt-tightening. As a result, any effort at budget austerity to
improve its public finances is likely to be counterproductive in that it could
deepen any Italian economic recession.

The only orderly way out for Italy to deal with its debt
problem would be for the country to get on a higher economic growth path.
Unfortunately, however, Italy’s past record of sclerotic economic growth offers
little hope that this will happen. Since joining the Euro in 1999, Italy has
had the dubious distinction of being a country whose per capita income has
actually declined over the past 20 years.

Italy’s precarious debt situation and the approaching end of
the ECB bond buying activities have not been lost on the markets. In the space
of a few months, the spread between Italian and German government bonds has
doubled to over 200 basis points, thereby raising the Italian government’s
borrowing costs to over 3 percent. Things could get even worse as we approach
Italy’s July 2023 parliamentary elections.

All of this is of considerable importance to the world
economic outlook. In 2010, the Greek sovereign debt crisis shook world
financial markets. Now that the global economy is already slowing, the last
thing that it needs is a sovereign debt crisis in Italy, a country whose
economy is some 10 times the size of Greece’s.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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