Why Italy is too big to fail for the European Union
Italy's real financial problem, however, is not the annual budget shortfall but the country's mountain of outstanding debt.
The European Union and Italy have been in a standoff over the Italian government's debt for weeks. Brussels - supported by the rest of the governments of Europe - seems to believe that Rome will soon back down, delivering another victory for European Union discipline. But that's far from certain. Moreover, even if the Italian government does fall in line, the political consequences may prove disastrous for Europe. However, the drama ends, Europe is playing a dangerous game.
The confrontation began in October, when the government in Rome put forward a draft of its budget for 2019, which proposed an increase to Italy's deficit. On October 23, the European Commission rejected the budget - an unprecedented move. Since then, Brussels has initiated steps to penalise Italy under the European Union's strict excess-deficit rules.
Italy's real financial problem, however, is not the annual budget shortfall but the country's mountain of outstanding debt, running to a total of 2.6 trillion euros, most of which was piled up decades ago by political parties that no longer exist. Today the debt burden hovers around 133 per cent of gross domestic product.
Debts at this level can easily become unsustainable, growing faster than the income necessary to repay them. The debt is widely held by banks inside and outside Italy. A scenario in which Italy had difficulty meeting its financing needs would deal a shattering blow to Europe's fragile financial system. Given this delicate balance, there is little room for error. Every opportunity must be taken to lower the ratio of debt to gross domestic product.
With the eurozone's having experienced a modest recovery since 2013, and even Italy's economy growing again, the European Commission argues that Italy should tighten its belt. Rome demurs.
Of course, no government wants to embrace cuts. But there is a more basic point here: For the commission to declare Italy fit to make budget cuts just because the country has seen some growth is in glaring contradiction to actual economic and political conditions.
Over the past 10 years, Italy's gross domestic product per capita has fallen. This decline is unique among large advanced economies. (It is even worse than Japan's infamous lost decades.) And the suffering is extremely unevenly distributed: More than 32 per cent of Italy's young people are unemployed. The gloom, disappointment and frustration are undeniable. For the commission to declare that this is a time for austerity flies in the face of a reality that for many Italians is closer to a personal and national emergency.
The two parties that make up the current Italian government, the League and the 5-Star Movement, were elected in March to address this crisis. The League is xenophobic; 5-Star is erratic and zany. But the economic programmes on which they campaigned are hardly outlandish. The League wants tax cuts for its core constituency of small businesses. The 5-Stars want a minimum income guarantee for their voters in Italy's poorer southern regions. Both want to coddle Italy's pensioners. These proposals will increase the deficit. But at the same time, Rome argues, they will deliver a much-needed stimulus.
Even on the European Commission's pessimistic assumptions, the deficits proposed by Rome wouldn't send the debt burden out of control. What would tip Italy into real crisis would be a sudden upward adjustment in yields not to 3 per cent but to 5 per cent or more. If that were to happen, caused by a shock to the market's confidence in Italy, there would be an explosive surge in debt service costs. The European Commission is, of course, bound to defend its rules. But how does the European Union expect the confrontation to play out?
Brussels has a limited range of sanctions at its disposal. Unlike Greece, which was a net recipient of European Union largesse, Italy is a net contributor to the European Union's budget. It won't be easy to make penalties and fines stick. It will therefore have to be the markets that deliver the discipline. But that is a terrifying prospect: Not only is Italy's debt huge, but Italy's banks are not minnows, either. Italy is both too big to fail and too big to bail.
So what is the game plan? If the commission is gambling that the budget crisis will force Italy's government to fold, what direction does it imagine the government folding in? On the back of its election victory, 5-Star was the senior partner in the coalition formed in May. But the balance of power has shifted. While 5-Star's popularity has slid, support for the League has doubled. If strengthening the League is not the commission's intention, perhaps Brussels is hoping for a tactical withdrawal by Rome. A face-saving compromise may yet be arranged over the expensive pension proposals. If the government crumbles, a new election might yield a more compliant majority.
But this is, to say the least, a high-risk and negative strategy. Above all it fails to address the deep sense of crisis in Italy. If the European Union is determined to hold the line on debt and deficits, it should offer something positive in exchange, such as a common European investment and growth strategy or a more cooperative approach to the refugee question, which has driven the upsurge in the League. If all Brussels has to offer is discipline, it is inviting the remaking of Italian politics along lines that are more nationalist and more hostile to Europe.
Adam Tooze is a British historian who is a professor at Columbia University