Rising Interest Rates Risk Italy Being the Epicentre of 2023 Eurozone Crisis

There was consternation in Italy recently with The Economist’s characterisation of the British Tory Ominshambles as ‘Br-italy’, because it played into outdated stereotypes. And, with good reason.

Italy has had 68 governments since World War 2, run up massive public debts and regularly resorted to currency devaluation rather than harder-to-do policy reform to maintain competitiveness. Relatively short-lived governments are still the norm, with Giorgia Meloni having recently become the 7th PM in ten years at the head of a Brothers of Italy party that can trace an authentic neo-fascist lineage.

Fiscal profligacy and currency devaluation, however, were very much 20th century phenomena. Italy has been able to respond appropriately with fiscal stimulus to both the global financial crisis and the Covid-19 pandemic, in line with peer countries. But, Eurozone membership has greatly constrained Italian policymakers since the mid-1990s.

The point is not to say that this is right, just to recognise reality. Whether due to internal restraint or external constraint, Italy has been a relatively ‘well-behaved’ Eurozone member in the eyes of the European Commission and ECB. It hasn’t really had a choice.

In the decade either side of the Euro’s launch in 1999, Italy managed to bring down its debt-to-GDP ratio from over 120% to 105%. This was no mean feat, albeit still far in excess of the supposed Maastricht limit of 60%. It hardly budged until the global financial crisis, after which it spiked to 135%. Five years of austerity saw that ratio fall slightly year-on-year before it spiked to 155% in 2020 during the pandemic. In November, Meloni’s government announced an increase in its planned budget deficit for 2023 to fund measures to tackle energy costs. But, she has already vowed to slash welfare and rowed back on election promises to hike pensions and cut taxes. Italy will soon be back in austerity mode.

Arguably, the combination of austerity and supply-side reforms, and what neoliberals would call macroeconomic stability, have come at the cost of continued political instability. That this policy mix was often implemented under technocratic Prime Ministers that hold sway in European corridors of power compounds that impression. Italians have had enough. As in some other European countries, the large centre-right and centre-left political parties have fractured, giving rise to surging support for populists outside the mainstream: first the Five Star Movement, then Lega under Matteo Salvini, and now Meloni’s party.

But, Italy is still paying the price for its 20th century debts. It has a huge government debt overhang while the era of low interest rates has ended. This is a big problem for Europe, and for the Euro Zone in particular. If Paschal Donohue is reelected to lead its group of Finance Ministers, he may have his work cut out in 2023. The ECB is no longer led by Mario Draghi, credited with saving the euro by uttering three words in 2012: “whatever it takes”. The ECB is aggressively raising interest rates and preparing to wind down its government bond holdings. Its current President, Christine Lagarde, has said explicitly that it is not the bank’s function to hold down Italian interest rates. Neither is Draghi nor his ilk leading Italy’s government, which he was for much of 2021-2022.

In this environment, a fiscal, economic and political crisis in Italy cannot be ruled out in 2023. Putin is not the only spectre haunting Europe.

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