November 15, 2018 | By Brian Hanson, Isabelle Mateos y Lago, Adam Tooze

Deep Dish: The 'Doom Loop' Potential of Italy's Eurozone Clash

For the first time ever, the European Union rejected a proposed budget from a member state: Italy. A deadlock has ensued, threatening a "doom loop" that could consume Italy's economy, the eurozone, and perhaps global markets. Former International Monetary Fund official Isabelle Mateos y Lago and Adam Tooze, economic historian and author of Crashed: How a Decade of Financial Crises Changed the World, join Brian Hanson to discuss this issue.

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Brian Hanson: This is Deep Dish on Global Affairs, going beyond the headlines on critical global issues. I'm Brian Hanson. Today we're talking about the economic clash between Italy and the European Union, with the possibility, some are discussing of a new European debt crisis. While we in the US have been focused on the mid-term elections, in Europe something unprecedented and important has just happened. For the first time ever, the European Union actually rejected the proposed budget of a member state, in this case, Italy. Just yesterday, Italy submitted a revised budget to the European Union, which essentially had the same provisions which where rejected before. I was in Brussels last week, and the talk of the town was whether Italy was going to plunge the Eurozone into a new financial crisis. For some even raising the question of will the Eurozone survive. To help us unpack what's going on, way it matters and what can be done, I'm joined today by Isabelle Mateos y Lago, who is a former official of the International Monetary Fund, and now with the investment firm Blackrock. Welcome, Isabelle. Great to have you here.

Isabelle Mateos y Lago: Thank you for having me.

Brian Hanson: Also with us is Adam Tooze, an economic historian and professor at Columbia University, who also directs the European Institute there and has a terrific new book called "Crashed, How a Decade of Financial Crisis Changed the World." Welcome, Adam.

Adam Tooze: Hi. How are you?

Brian Hanson: Isabelle, let me start with you. Just at a fundamental level, why are people concerned about this Italian budget? If you look at it on the surface, you're talking about a deficit of only about 2.4 percent of GDP, which on its own, doesn't seem like that big a deal. Why are people so concerned about this budget and its implications?

Isabelle Mateos y Lago: I'd say two reasons. The first one is that you can just look at one year's fiscal deficit in isolation. You have to look at the broader context which is that Italy has the highest debt to GDP ratio in the Eurozone after Greece. It's 130 percent. It's quite high, and it has a very low growth potential. I think markets can easily turn, concerned about the debt dynamics in this kind of situation. And a country that decides to essentially stop doing fiscal adjustment in that context immediately raises eyebrows. But the second reason, which is perhaps even more important, is this decision of the newly elected government to openly defy the common fiscal rules that other EU members have agreed to live by. That has rekindled fears of a break-up of the eurozone quite clearly. That doesn't mean it's going to happen tomorrow or that it's going to happen at all, but just the fact that this fear is back on the radar screen has spooked markets.

Brian Hanson: In many ways, this isn't all that unexpected. We did the Deep Dish episode right after the Italian elections. This government is often characterized as a populist government, aligning the Five Star Movement and the Northern League that campaigned on increased spending. So is this much of a surprise of what the Italian government actually doing? Isn't this what the voters asked for when they elected this coalition?

Isabelle Mateos y Lago: No, you're absolutely right. I actually thought you might direct this question to Adam, because it follows quite directly I think from everything in his book leads to. Italians are fed up. They haven't seen any growth basically since joining the euro, but certainly they're still far worse off than they were at the time of the global financial crisis and they want something else. They voted for something else. This government, quite sensibly, is trying to give it to them. The problem though is that the way they're going about it, is not convincing anybody that they're going to solve the growth problem that Italy has in a sustainable way. In fact, the concern is they're going to make things worse. You can see that also very clearly in the statement that the IMF issued a couple of days ago and what the Commission has essentially been telling them. I think that's the concern.

Brian Hanson: Adam, what are the implications of this? If Italy goes down this path, spends at his level, doesn't really address its debt level, not increasing its growth. What are the consequences? What are the concerns about that situation? What can happen?

Isabelle Mateos y Lago: I think following Isabelle's expert analysis. There are two types of crisis that arise after this. The first is the possibility of a truly terrifying escalation of debt dynamics, and it would get really bad if it spilled into what we used to call the doom loop scenario, where the crisis is a major European sovereign debtor pulls down the creditworthiness of its banks, which hold a lot of that debt. Then we would be in a really dangerous terrain. But the other fundamental problem is that we are back in that terrible clash between what we take to be economic and financial imperatives on the one hand and democratic sovereignty on the other, and that is an extremely difficult, painful and indeed in some sense dangerous place for the Eurozone to find itself.

Brian Hanson: Let me ask you to unpack a little bit more about the banking doom loop. Essentially here the concern as I understand it is that if the debt gets too high and the Italian government is not able to repay the debt or if the market ends up increasing interest rates in Italy, and they're unable to repay that debt. As you said, they would default and others who hold that debt, a bond just being an IOU, all of a sudden have something that's worthless. And why can that lead banks to fail? Just unpack the mechanics a little bit for us.

Adam Tooze: There's lots of them. It depends how these are calculated. But insofar as their debt portfolios are what's called mark to market. They have to adjust them to the market evaluations. The Italian banks are actually shuffling large parts of their sovereign debt holding out of that segment of the balance sheet. In their mark to market balance sheet, they have to recognize essentially loses, which causes fundamental problems. It destabilizes the banks. To complete the loop, then you need to take action to stabilize the banks, which imposes fiscal stress on the government. This is the second phase of the doom loop. It's what we saw in Ireland. It's what we saw in Spain in 2012. That's when the Eurozone really triggered into full emergency mode, where the ECB stepping in after there was an agreement on banking union to try and break the loop. That I think is, as far as I can see, what the markets are betting on. If this should go bad, it would take some kind of intervention by the ECB. But we've no idea what framework that would take place within.

Brian Hanson: So the ECB being the European Central Bank, similar to what people here think of the US Central Bank, but for the entire Eurozone. Go ahead, Isabelle?

Isabelle Mateos y Lago: If I can jump in on this doom loop. I agree entirely with what Adam has said. But I think there's a more immediate corrosive manifestation of this type connection between the banks and the sovereign, which is that essentially for every increase in the sovereign spread, you've got capital erosion. Because of this mark to market phenomenon that Adam was talking about. You don't need to wait for the sovereign to default. Every day that the spread goes up, the banks are finding themselves a bit squeezed. Their cost of capital goes up. They're encountering funding difficulties. Already the funding market is shut down for all but the top two to three Italian banks. That makes it a lot harder for them to extend credit to the economy. While the goal is trying to stimulate the economy with this fiscal stimulus, in fact it's going to create a credit crunch, which is going to slow down the economy, the opposite of what they're trying to do.

Adam Tooze: Then we have threshold effects where we have every rating of either the banks or the sovereign. They get downgraded in terms of their credit standing. That really further binds their financing. That's something that can happen that the markets will anticipate it. But the shock of an actual downgrade can create a cliff effect.

Brian Hanson: One of my understandings why a cliff can be so severe is that some funds, some investors, are only allowed to invest in debt that has a certain quality, that is very likely to be paid back. The ratings can cause, if it drops out the level, can cause the automatic disinvestment from that kind of debt. Is that the challenge?

Adam Tooze: Yeah, and the biggest buyer of all is the ECB, which also has collateral rules that specify that it's only content really to buy European sovereign bonds which are investment grade rated. Italy is one or two notches above losing that standing. After that, the ECB would really be an unknown territory if it was still going to buy Italian bonds after they've lost their investment grade and status.

Brian Hanson: We've talked about the effects inside Italy. I want to take this to how it could spread more broadly in Europe. As I recall from the Greek financial crisis, one of the big challenges was that the banks that held much of that debt were in places like Germany. It was German banks that were going to get in trouble as well. So far we've talked about the effect on Italian banks. For Italy's debt, who holds this debt? Who has the risk of it becoming worthless on their balance sheet?

Isabelle Mateos y Lago: It's mostly Italy. Italy is the largest debt market in Europe. Pretty much every financial institution that owns eurozone bonds has some exposure to Italy. But if you have to do a league table, France would come out on top in terms of exposure, not just to the sovereign debt but to the Italian economy as a whole. The parallel with Greece is the obvious one that comes to everybody's mind because it was the last time that we had a serious scare and a serious confrontation between a freshly elected populist government and the European establishment.

So to speak, Italy is actually a quite different beast than Greece and anybody who's thinking of applying the same playbook would be up for some surprises. I think Italy is massively bigger. Italy is in a stronger position in many ways then Greece. It has a current account surplus. It has a primary fiscal surplus. It is a net contributor to the EU. It's going to be much more difficult for the EU to bully Italy into submission to its rule. In fact, it probably doesn't have any serious enforcement mechanism other than market pressure. In theory, it could impose fines but that's never been done and it would almost certainly be counter productive from a political standpoint. My bet would be we're not going to see an escalation until the European elections, the European Parliament elections, which takes place at the end of May of next year. Because the last thing the EU wants is to fuel populism around Europe. After that the odds are a bit bigger.

But I think the point that the EU doesn't really have a credible enforcement mechanism other than market pressure is going to remain and that's very different from Greece.

Brian Hanson: I was just going to remind listeners of what the strategy was in Greece. To be really simplistic about it, essentially there were bail out funds provided by the European Central Bank and the IMF in exchange for austerity measures, budget cutting measures inside of Greece that were very, very drastic. As I listen to you Isabelle I'm hearing that on both counts Italy is a far more challenging case. It's a much bigger economy, so the amount of money that would be needed to bail out Italy would be far greater. And also where Greece was so dependent on the European Union and European Union funds, Italy with net surpluses, you pointed out, in the European Union is a contributor to Europe and just a bigger and stronger country that's less likely to be able to be forced into the kind of austerity that Greece accepted. Is that a fair characterization? Adam?

Adam Tooze: I'm thinking one can overestimate the significance at this point about scale. Italy is 10 times the size of Greece, in terms of the public debt that issued. It's not just the largest public debtor in the Eurozone, it's the fourth largest in the entire world. This is a problem that surpasses the scale of the eurozone. Though it's true that Italy is a net contributor to the EU budget, that's a relatively small piece of the problem. Because the real issue is can the Italian government refund itself next year. It's refunding needs are enormous. It's several hundred billion euros a year, I think maybe something like 260 billion euros that it needs to raise in the next 12 months, simply because old debt is coming due and that needs to be refinanced and then even though there is a primary surplus, an overall deficit because of the interest payments, which are getting more and more expensive as yields and interest rates rise.

Though it is true that the Eurozone has relatively few means of pressure, there is the very distinct possibility of a bond market crisis. I think the question really is, to me anywhere the nightmare scenario seems to me a crisis which neither the commission nor the Italian government necessarily wants to bring on deliberately, but as it were an accidental slide into such a scenario. At that point, though it's true that Brussels would have very few means of leverage over them, it's also true that it doesn't have anywhere near the resources in place currently to provide the bail out. What we need to do is essentially provide for the immediate funding needs of the Italian government and then potentially also the issue of the Italian banks.

Isabelle Mateos y Lago: I wouldn't over stress this point. It's true if you're specifically speaking, if you look at the amount of resources that the European stability mechanism would be able to lend to Italy, that would likely not be enough. But I think the idea and that kind of circumstance is you have an ESM program to unlock backing by the ECB. At that point, the resources are infinite. I don't think a binding constraint is going to be the resources. The binding constraint is going to be the political willingness of this Italian government to submit itself to the strictures of an ESM program. That I think is very much an open question, considering that some prominent members of one of the parties in the government coalition have openly been saying that they would welcome leaving the euro. Not the prime minister himself but some voices inside this coalition government or have made clear where their heart lies. This is why it's such a headache for the Eurozone, in terms of how to deal with it, if we come to that point.

Brian Hanson: That gets me to exactly where I want to go. This sounds like a pretty doggone difficult situation. What are the options? What can done? What do you think the best paths forward for managing this crisis are? Adam, happy to start with you.

Adam Tooze: If you talk to senior European commission officials when they reach the negative and depressing point that you just did, they start telling you about the possibility of a shift in Italian public opinion. I think one of the ways out of here is that the logjam is broken by a shift in the Italian political scene, which however is polarized. On the one hand, there's strong evidence of the consolidation of support for continued Italian membership in the Eurozone or the EU. On the other hand, the Northern League, which is the more aggressive nationalist element that the coalition has also been able to consolidate its support. It's not clear exactly where that shift would come from. But that's certainly one of the ways I think in which people in Brussels hope that this logjam might be broken.

Isabelle Mateos y Lago: Again on a technical level, there's all sorts of things that could be done. You could easily create a situation with the ECB doing another refinancing operation like the LTRO, you could have some kind of debt re-profiling with the help of the assent. There are technical solutions but they would all be predicated on the Italian government agreeing to run somewhat sensible policies that would give both market and EU partners confidence that at the end of the day, the debt is going to be sustainable. The difficulty comes from I would say the politics. Again is this government going to be willing to accept policies that make its debts sustainable over time. For that, it's not just a matter of fiscal adjustment. It's also a question of doing something to boost the abysmal productivity growth that Italy has had, to boost its growth potential. To me, that's the difficulty. It's not that the problem is without solutions. It's rather that it could take a long time to come up with one and during that time, a lot of damage could be done in terms of economic growth and in terms of markets.

Adam Tooze: The 130 percent of GDP which Italy is already at is widely considered to be quite a dangerous threshold. There's a three cornered problem in that you have the system, long term unemployment which is devastating, especially for the young people in Italy. There's over 30 percent unemployment amongst young people in Italy. You have the problem with productivity which Isabelle has alluded to. That in a sense demands some sort of constructive aggressive fiscal response. But the debt level on the one hand and the system's problems with productivity and an efficiency both in the private and the public sector in Italy suggests the need for a variety of more painful reform messages as well. It's really difficult to see how you combine all of those three ... a policy that meets all of those three criteria within a political framework but can actually support a government and command the majority in Italy.

Brian Hanson: It sounds like there are a couple ways this can go. It's fascinating that we're fundamentally down to political choices and the effects inside the society. Are there voices that matter inside Italy that are calling for a different route forward that could address those challenges of growth and unemployment without contributing to the increase of the debt? Or is this really up to the governing coalition and they're going to have to be the ones to sort it out? Because the opposition really doesn't have a voice.

Isabelle Mateos y Lago: Well there are voices but they're not represented in parliament right now. They're probably going to get wiped out even more in European elections. The one positive scenario that one can think of is that fundamentally the two parties in this corelation are not compatible. One would think this is not a sustainable coalition and maybe at some point it breaks and Lega forms another government with the center right. At that point, maybe your better equilibrium could be found in terms of business-friendly and market-friendly agenda. But it could be awhile before that happens. Market accidents can happen in between.

Adam Tooze: The view from the other side of the political spectrum I think one also has to say that if many of the fundamental problems in the allocation of government spending in Italy go back a century to a generational divide, a divide between older people who are gaining the benefits of the Italian welfare system and pension system, have some form of employment that inside, the system is benefiting from it. A large percentage of younger Italians who are excluded from all of those benefits, demographic change has shifted the balance of power towards older generations in Italy. But five star is preeminently a movement of frustrated, angry young people above all in the South. Another way of viewing the logjam that has to be broken in Italy is that there has to be a shift between the generations. There has to be improvement in the education system. There has to be a shift in priorities of government spending away from ... and the pension system and older Italians towards the younger people in whom the viability of the system in the long run depends. That is another dimension of the shift that we need to bear in mind.

Brian Hanson: As I listen to this, clearly the challenges are very, very significant all around in how to address this problem. One of my impressions of the Greek crisis was it was basically a muddling through policy. It became very intense when there were market reactions that need to be responded to. I want to close with putting the situation in Italy and in Europe in a bigger global context which is to what extent can what's going on in Italy lead to a bigger economic meltdown? Obviously from the United States in 2008, we saw how financial choices made in this country and policies led to a worldwide contagion. Is this a solely European problem or does it have the potential to have more global impacts?

Isabelle Mateos y Lago: What we saw the last time there was a huge tension around the eurozone is that it had a global impact but a differentiated one. If you look at the impact on the US the main impact was to put downward pressure on US rates because that was the safe haven and people went into the dollar and people went into US rates. But it was very bad for risk assets worldwide, EM assets. There's no direct, not much of a direct economic impact but there was just a huge increase in risk aversion. I would expect the same thing to happen this time around.

Adam Tooze: Many of the more specific linkages between the American financial system and Europe that were very intense and a key element in the crisis between 2008 and 2012 running both ways, both European banks involvement in American subprime and huge exposure of the American money market in mutual funds the European bank that ... much of that interconnection, having that been downsized since the crisis, that direct channel I think is no longer quite as active and powerful as it was. Throughout the eurozone crisis between 2010 and 2012, the Obama administration was all over the politics of the Eurozone, in part because those feedback loops. The flow back to the US was considered to be such a serious risk. There is a scenario and it's a low probability nightmare scenario. But there was certainly a scenario in which the eurozone fails to keep control. This crisis actually does escalate. Then I think all bets are off.

But I agree with Isabelle. This is a low probability event but if we did see that kind of runaway firestorm type crisis, then the shock by way of risk aversion could be potentially quite massive simply because of the scale of the Italian problem. But that's a tail type risk. But it's there, simply given the scale of this debt pile.

Brian Hanson: Isabelle Mateos Y Lago of Blackrock and Adam Tooze of Columbia University. Thanks both of you for coming on and helping unpack what's going on in Italy. As I said up top this is an important issue that was overshadowed by the elections and now with Brexit getting so much attention which obviously is an important issue itself, I think it's been very helpful to raise our understanding of what's going on in Italy and why this standoff is so important. So thank you for being here.

Isabelle Mateos y Lago: Thank you very much.

Adam Tooze: Thank you.

Brian Hanson: And thank you for turning into this episode of Deep Dish. If you like the show, do me a favor and tap the subscribe button on your podcast app. You can find our show under Deep Dish on Global Affairs wherever you listen to podcasts. And if you think you know someone who would like today's episode please take a moment to tap the share button and send it to them as well. I'd like to invite you to join our Facebook group, Deep Dish on Global Affairs, where you can ask our guests follow-up questions about anything you heard today or submit questions for upcoming guests and ideas for upcoming episodes. That's Deep Dish on Global Affairs on Facebook. As a reminder the opinions you heard today belong to the people who expressed them and not the Chicago Consul on Global Affairs. This episode of Deep Dish was produced by Evan Fozio. Our audio engineer is Andy Zarnicki. I'm Brian Hanson and we'll be back soon with another slice of Deep Dish.

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