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Italy’s threat to the euro has not gone away

The Italian government remains on a collision course with Brussels despite recently striking a deal over its 2019 budget. A mis-step by either side could lead to a fresh euro zone crisis that the new head of the ECB might struggle to contain.

7 minute read

banca d italia

In July 2012, at the height of the euro zone sovereign debt crisis, Mario Draghi, president of the European Central Bank (ECB), famously declared he would do “whatever it takes” to preserve the euro. The expression of resolve – in effect daring investors to bet against the bloc’s bond markets and its currency – proved a turning point in a crisis that had begun in Greece in late 2009.

However, seven years on, and with Draghi’s eight-year tenure ending in October, the economic recovery his vow helped inspire is in danger of stalling as trade tensions and weakening global growth weigh on activity. Whereas a year ago the ECB chief had been hoping to deliver at least one rate hike before stepping down, it now seems his parting gift will be a further dose of policy stimulus.

Worryingly, with interest rates already skirting the ‘effective lower bound’, the effectiveness of any potential monetary policy remedies is in doubt. Draghi himself recently warned that in order to reap the full benefits of the central bank’s policy stance structural reforms need to be stepped up “substantially” across the euro zone. Inevitably, comparisons are again being drawn with the experience of Japan during its so-called ‘lost decades’; the similarities including an increase in government debt, a build-up of bad loans at banks, an ageing population and huge monetary policy loosening.1

Italy: an existential threat to stability?

With the exception of 2009 and 2010, Italy has run a primary surplus every year since 1991.

In truth, while the ECB succeeded in bringing down bond yields and shoring up its currency, fears the euro was heading for another potentially existential crisis at some point never went away. Although the ECB’s actions provided some respite, growth has remained weak and unevenly distributed. The continued lacklustre performance of the Italian economy, the bloc’s third biggest, remains an overriding concern.

In real terms, Italian GDP is more than three per cent below where it stood at the start of 20082, while the country’s jobless rate stood at 9.9 per cent in May, with youth unemployment at 30.5 per cent, the third highest in Europe.3 Feeble growth has prevented Rome from getting its deficit – the euro zone’s biggest in nominal terms and second biggest after Greece relative to economic output – under control. With the exception of 2009 and 2010, Italy has run a primary surplus every year since 1991.

Despite that, debt as a percentage of GDP has risen steadily as debt servicing costs exceeded economic growth. Debt last year reached 132 per cent of GDP, up from 112.5 per cent in 2009, and well above the 60 per cent threshold set by the EU.5

Italian bond yields have plunged since the start of June when Rome said it would cut public spending by €7.6 billion this year to avoid being fined by the European Union for flouting its rulebook. The rally in bonds was given further impetus when the European Commission responded to Italy’s pledges by ruling on July 3 that it would no longer issue an ‘Excessive Deficit Procedure’.6

Italy 10 year yield and spread over Germany
Source: Bloomberg

The yield on ten-year debt, having hit a five-year high in October 2018, has since more than halved, while on July 5 30-year yields hit their lowest level in more than two and a half years.7 The improvement in sentiment helped ensure Italy’s issuance on July 7 of €3 billion of 50-year bonds, carrying a yield of 2.88 per cent, was heavily oversubscribed.8

However, the frailty of Italy’s economy, the parlous state of its finances and the confrontational approach its populist government is taking with Brussels, mean the long-term outlook for Italian government bonds remains highly uncertain. The EU may have let Rome off the hook for now, but its simmering feud with Italy’s coalition government, which came to power in June 2018, is unlikely to subside for long. 

Suspicious minds

The EU executive, wary of the Italian government’s commitment to get deteriorating public finances under control, says it will be monitoring events closely. Its suspicion is understandable considering the mixed messages coming from the Italian capital. On the one hand Rome says its 2020 budget, slated to be drawn up this autumn, will continue to comply with EU rules. But on the other, with budget projections for next year more than 40 billion euros short of what the EU is demanding, spending cuts, tax hikes or a combination of the two will be required if a showdown with a newly installed European Commission is to be avoided.

The result of European elections at the end of May cast doubt on Rome’s willingness to accept such unpalatable medicine. They saw the Lega (League) party, led by Matteo Salvini, bagging 34 per cent of the vote – double its haul at the national elections just over a year earlier, as the deputy prime minister’s Trump-like “Italians first” message resonated with voters.

For the past year Salvini’s Eurosceptic party has been the junior partner in a coalition government led by the anti-establishment Movimento 5 Stelle (Five Star Movement). However, with Five Star having lost its crown as Italy’s biggest party, the European elections cemented Salvini’s position as the country’s most influential politician. Few doubt he will use this to exert more influence over government policy. The right-wing firebrand was soon bragging: “I don’t govern a country on its knees”.9

Rome may have backed down in June but Salvini seems aware that, since it could cause major problems for the currency union by allowing the deficit to spiral higher, Italy has leverage and wants to start using it. He appears to be itching to flout EU fiscal rules he recently described as “obsolete”. “I am not going to hang myself for some silly rule… We need a Trump cure, a positive fiscal shock to reboot the country,” he said.10

Rather than tightening fiscal policy, as the EU seems certain to demand, he wants to loosen it. To boost growth he has promised a flat income tax of 15 per cent as part of a €30 billion fiscal stimulus programme.11 In a weakened position after its disappointing showing in the elections, Five Star, having opposed tax cuts in the past, now says it backs Salvini’s plans but will not accept any cuts to health or welfare spending.

Brexit: a cautionary tale

A fresh clash with Brussels seems guaranteed should a fiscal stimulus of this magnitude go ahead. It would increase Italy’s deficit by 1.6 percentage points, which would almost certainly result in the country breaching the EU’s three per cent deficit limit.

The EU can ultimately slap a fine of up to 0.5 per cent of GDP, equivalent to €9 billion, to try to bring it to heel. However, whether Brussels will have the nerve to go ahead with the potentially nuclear option of fining a member state is unclear. Not only has it never done it before, having failed to penalise repeat offenders Spain and Portugal in 2016, it is acutely aware of the dangers of fanning anti-EU sentiment as it attempts to usher the UK out of the bloc.

Those supporting leaving either the euro, or the bloc altogether, remain a small minority. 

At the same time, it is far from clear Brexit has tilted the balance of power in Salvini’s direction. Although Italy has in recent years gone from being one of the most enthusiastic members of the EU to one of its most disaffected, those supporting leaving either the euro, or the bloc altogether, remain a small minority. The political crisis gripping Britain has provided a stark warning of the perils involved.

While Salvini remains highly critical of Brussels, and has in the past voiced strident Eurosceptic views, for the moment he appears to want to retain Italy’s membership of both the EU and the euro.

“We have no intention of leaving Europe, we want to change it, improve it, but not abandon it,” he said in February.12 The comments, designed to reassure Italians and financial markets, reined in the League’s economics chief Claudio Borghi after he said either the EU changed “or we’ll need to leave it”.13 Salvini has likewise backtracked on earlier threats to pull Italy out of the euro.


Just where the balance of power lies remains to be seen, not least given the new European Commission leadership, and Christine Lagarde, Draghi’s nominated successor, have yet to get their feet under their desks. History suggests both sides will eventually reach a compromise in the near term, in time-honoured fashion kicking the can down the road. But the longer-term outlook is increasingly worrying.

Italy is trapped in a vicious circle with no easy means of escape. While the country has long been plagued by a poor demographic position, the situation has in recent years deteriorated appreciably. Young Italians – most of them skilled and educated – have left the country in record numbers over the past decade. According to official statistics, almost 157,000 Italians moved abroad in 2018, the most since 1981. At the same time, the country’s birth rate has been dropping, last year tumbling to the lowest level on record.14

Nearly 23 per cent of Italians are 65 or older, the second-highest rate in the world after Japan.

With the country boasting the highest life expectancy in Europe - 83 years - its population is ageing rapidly. Nearly 23 per cent of Italians are 65 or older, the second-highest rate in the world after Japan.15 That is putting extra pressure on finances. At around 16 per cent, public pension costs as a share of GDP are the second-highest among 37 OECD countries, after Greece.16 Worryingly, Italy is in the process of lowering its retirement age, reversing the ‘Fornero’ pension reforms of 2011 that aimed to make the system more affordable.

Mini-BOTs: remedy or ridiculous?

With the economy already teetering on the brink of recession, the danger is that a serious downturn emboldens Salvini to challenge the EU’s fiscal rulebook more aggressively, or to circumvent it altogether. Rome is already talking of issuing low-denomination, non-interest-bearing treasury bills (‘mini-BOTs’), to circulate alongside euros, as means of escaping the EU’s fiscal straightjacket. A recession could hasten such plans.

If the government paid its creditors in mini-BOTs… Salvini could cut taxes without expanding the official money supply.

As a member of the euro, Italy cannot legally issue its own currency. But if the government paid its creditors in mini-BOTs – and if it agreed to take them back again as payment for taxes, or goods and services provided by the state – Salvini could cut taxes without expanding the official money supply.

Draghi is unimpressed. “Mini-BOTs… are either money and then they are illegal, or they are debt and then that stock goes up… I don’t think there is a third possibility,” he said.17

Since fiscal policy is within the domain of national sovereignty, it is unclear the EU can prevent Italy from issuing mini-BOTs. But if Rome goes down this route it would take its confrontation with Brussels to a new level. The recent history of Greece suggests Salvini will come under enormous pressure to avoid such a confrontation. In January 2015 Syriza, a coalition of left-wing parties, swept to power after vowing to tear up Greece's bailout programme and end austerity.

But six months later, under pressure from the EU, with capital controls on its banks and faced with the threat of being ejected from the euro, Syriza was forced into a humiliating U-turn, signing up to a third bailout and more austerity. It was kicked out of power in July.

The EU seems certain to count mini-BOTs as part of Italy’s official deficit and debt. It can argue that if people used mini-BOTs to pay their taxes, the Italian government’s future euro tax revenues would decline, and with it the country’s capacity to service its euro-denominated debt. 

The handover from hell?

Ultimately, mini-BOTs will not allow Italy to escape the EU’s rulebook. And if it refuses to abide by the rules, the ECB will almost certainly come under pressure to shun Italian government debt were it to resume quantitative easing. With the ECB having so far bought €365 billion worth of BTPs, this would force yields sharply higher and have a devastating impact on the government’s ability to finance its debt.18

However, much as Salvini needs to be alert to the risk of unsettling bond markets, the EU also needs to tread carefully. The recent European elections suggest that if the current government were to collapse, new elections could result in a landslide victory for the League. That would be even more likely if Brussels were to take a hard line with Italy, enabling Salvini to whip up anti-EU fervour. The danger for Brussels is the more he is politically cornered, the more likely he is to lash out.

Despite the sharp drop in Italian government yields in recent days, spreads over German bunds remain comparatively high. With the ECB seemingly poised to start buying bonds once again to try to invigorate growth, the market looks to have room to rally further in the near term. But investors will need to keep a close eye on economic and political developments.

Draghi may have ‘saved’ the euro in 2012, but it only ever looked to be a temporary fix. Should Salvini resort to issuing mini-BOTs, the euro zone crisis is likely to return, potentially with even more devastating consequences than before. After all, Italy’s economy is ten times the size of Greece’s and its government has about nine times as much debt outstanding. Lagarde, if and when she replaces Draghi, may face an even harder job repeating the feat.


  1. The euro zone’s Japanification, ING research note published 24 June 2019
  2.  Italian Statistics Office
  3. Eurostat
  4.  International Monetary Fund
  5. Eurostat  
  6.  European Commission
  7. Thomson Reuters
  8.  Italian finance ministry
  9. Italy to activate its 'parallel currency' in defiant riposte to EU ultimatum. Daily Telegraph, 29 May 2019 
  10.  ibid.
  11. Salvini presents League flat-tax proposal costing 30 bn. ANSA English edition, 28 May 2019 
  12.  Italy’s Salvini Says Country Won’t Leave EU, Just Wants Changes. Bloomberg, 15 February 2019 
  13.  Europe vote will decide if Italy stays in EU - League lawmaker. Reuters, 15 February 2019
  14.  Italian Statistics Office
  15.   World Bank
  16.  OECD
  17. ECB Press Conference remarks, 6 June 2019
  18. European Central Bank

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