Italy has had 64 governments since 1946, which works out to an average of 410 days per government. The latest iteration, under Prime Minister Paolo Gentiloni, is 533 days old, so really it’s about time for a new one, and the markets were reasonably sanguine about that development, even when the new government was set to be run by populist extremists.
The news that the winners of the last election won’t form a new government, however, has devastated the Italian bond market and sparked fears of a brand-new euro crisis—one which, by dint of Italy’s sheer size, would be vastly worse for Italy and the world than the last one.
A bit of background: In March, Italy voted to kick out all of the parties that have historically formed governments since the war and instead voted in a combination of reds (the Five Star Movement, founded from the left by neo-anarchist comedian Beppe Grillo) and the browns (the xenophobic League, Italian avatars of the far right). When the two diametrically opposed parties decided they could work together to form a government, they nominated 82-year-old euroskeptic Paolo Savona as their finance minister. That was too much for Italy’s president, who has rejected Savona and asked for someone else (which doesn’t feel very democratic but is his constitutional right); the League refused, and now it seems that Italy is headed for yet another election.
This isn’t a fully blown crisis yet, and right now the balance of probabilities is still that there won’t be one. In order to get to Actual Crisis, two things still need to happen: The coming election needs to be turned into a referendum on EU membership, and the anti-euro parties need to win it.
Neither of those two things is likely to happen because the Italian populace, as divided as it is, remains strongly in favor of the euro. They might hate elite politicians, and they might hate Brussels-imposed austerity, and they might vote for extremist parties like the Five Star Movement and the League—but they’re not about to vote to leave the euro, and the populists know that.
Still, no one thought Brexit would happen either. What if the unexpected occurs? The recent market jitters give a pretty clear idea of where Italy would be headed were it to leave the euro. The indicator that everybody’s looking at is the yield on the benchmark two-year Italian government bond—that is, how much annual interest you get if you lend the Italian government euros that they will repay in two years’ time. At the beginning of this year, the yield stood at -0.137 percent, which meant that for every 1000 euros you lent the Italian government, you would get back about 997 euros two years later. The credit of the Italian government was considered so good, in other words, that investors were happy to accept negative interest rates just to ensure that their money was in a super-safe place.
Interest rates rose a tiny bit after the populists did surprisingly well in the March election, but they stayed negative. Even after the red-brown coalition formally agreed to form a government at the beginning of May, the interest rate on two-year debt was -0.151 percent.
Today, however, that interest rate is far from negative: At one point on Tuesday it spiked as high as 2.83 percent, which is by far the highest level that it has seen since the euro crisis of 2010–12. That isn’t the interest rate that Italy would have to pay on its gargantuan national debt (currently 132 percent of GDP) should it leave the euro; it’s the interest rate that investors are requiring now just because they’re worried that there’s a small chance that Italy might leave the euro.
Meaning, things can get infinitely worse. It’s no exaggeration to say that an Italian exit from the euro would constitute an international economic crisis of truly catastrophic proportions—much more troubling than anything we saw in Europe or the U.S. between 2008 and 2012.
Italy is too big to fail, but it’s also too big to rescue. While Greece could, ultimately, get bailed out by the European Union and the IMF, Italy can’t be. There just isn’t enough money. Without the low interest rates that accompany euro membership, Italy would be forced to default, and everybody who holds Italian debt, including virtually every major European bank, would be forced to take the kind of losses that lead straight to insolvency. Italy would become a disaster zone, but the rest of the world would suffer a major crisis and recession as well.
Ultimately, that’s why Italy’s president, Sergio Mattarella, refused to allow a euroskeptic to become finance minister. Governments come and governments go—that’s normal in Italy—but it’s Mattarella’s job as president to keep his country from self-destructing. He accepted the parties that won the election; he even suggested a different League representative as finance minister, one who didn’t want to bail on the euro. But the League didn’t bite, and the result is the current spate of nervousness and uncertainty, none of which is going to be resolved at least until the Five Star Movement and the League make it clear whether they’re going to fight the next election on an anti-euro platform. In the parlance of financial markets, we’re in “risk off” mode for the time being, with investors retreating to the safest havens they can find.
In the medium term, the likeliest scenario is that Italy, and the EU, will muddle through, and that all the money that has fled the country in recent weeks will find its way back. The future probably won’t be catastrophic, but that doesn’t mean it’s going to be pleasant. The markets and the technocrats have de facto veto power over Italy’s democratic decision-making, which means that outcome I’d most expect is actually more of the same. Or, as one person put it on Twitter:
