When it comes to gauging the Italian economic outlook, we would do well to remember Herb Stein’s famous aphorism: If something cannot go on forever, it will stop. If ever that aphorism was true, it has to be in regard to the Italian government’s continued ability to issue ever larger amounts of debt to cover its budget deficits. This is especially the case when there is little prospect that Italy will ever reduce the size of its public debt mountain.

Needless to add another round of the Italian sovereign debt crisis is the last thing that the world economy needs at this time of synchronized world economic slowing. The Italian economy is some ten times the size of that of Greece and it has a $3 trillion government bond market. If the 2010 Greek debt crisis shook world financial markets, how much more so would an Italian debt crisis do so today?

A principal reason to brace ourselves for another round of the Italian debt crisis is that all of the factors that might allow that country to reduce its debt burden are now moving in the wrong direction. This has to be of particular concern when today’s Italian public debt to GDP ratio is 145 percent or some 20 percentage points higher than it was at the time of the 2012 Italian debt crisis.

Purely as a matter of arithmetic, the three factors that might improve a country’s public debt burden are a healthy primary budget surplus (the budget balance after excluding interest payments), lower interest rates at which the government can borrow, and a faster pace of economic growth. Unfortunately, in Italy’s current case, all three of these factors are going in the opposite direction.

Far from producing a primary budget surplus, the disappointing Italian budget presented this week by the Meloni government implies a meaningful primary budget deficit. At the same time, in the context of European Central Bank (ECB) monetary policy tightening and investor questions about the direction of the current government’s economic policy, Italian 10-year government bond yields have risen sharply to close to 5 percent. That is their highest level since the 2012 Italian debt crisis.

Meanwhile, far from experiencing rapid economic growth, the Italian economy seems to be on the cusp of another economic recession: The fall-out from ECB monetary tightening to regain inflation control. Such a recession would hardly inspire confidence in Italy’s ability to grow its way from under its debt mountain given its sclerotic growth record. Since joining the Euro in 1999, the level of Italy’s per capita income has barely changed.

Until recently, the Italian government has had little difficulty in financing itself on relatively favorable terms despite its public debt mountain. That was largely due to the fact that under its aggressive quantitative program, the ECB covered almost the totality of the Italian government’s net borrowing needs. However, since July 2023, the ECB has completely terminated its bond buying programs. This makes the Italian government very much more reliant on the financial markets to meet its borrowing needs.

With Italy’s highly compromised public finances, it is especially important that its government instill investor confidence so that it is capable of managing a very difficult economic situation. For this reason, it has to be regretted that the far-right Meloni government has failed to deliver on its economic promises. Among its more disappointing missteps have been its botched windfall tax on bank profits and the introduction of a budget that envisages a 5.3 percent budget deficit that puts it on a collision course with the European Commission.

In recent days, the markets have refocused attention on Italy’s shaky public finances and sent the Italian-German government bond spread to its highest level since the start of the year. The Italian government should take note of the market’s shot across its boughs and change economic course soon if it wants to avoid a full-blown Italian debt crisis next year.

Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

This article was first published by the American Enterprise Institute.

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