"Kee" Points with Jim Kee, Ph.D.

We usually suspend Kee Points during holiday weeks like this, but I did have a few notes to share on Italy:

If you followed the business press over the weekend, you know that the Italian President  (Sergio Mattarella) blocked the formation of a new government, which would consist of two populist parties. One party is the northern pro-business, pro-tax cut interests known as the Lega, or League. The other is the southern Five Star Movement, which is more pro-welfare payments/higher pensions. Given Italy’s quirky or “arcane” (Asian Times) political system, Mattarella’s actions could prompt another election in the fall, if not sooner.

As I mentioned in a previous Kee Points, advocating for tax cuts (League) and welfare spending (Five Star) is pretty hard to do without increasing budget deficits, and therein lies Italy’s problem. At 130% of GDP, Italy’s debt in absolute terms is the largest in the Eurozone. With borrowing restricted from the last debt crisis, the only way for Italy to spend more and tax less without borrowing would be to print money for the additional spending. But Italy cannot do that because it is part of the euro currency area. That is what is leading to rumors of Italy leaving the euro, or issuing a kind of government “scrip” to pay its debts, sort of a parallel currency that would not sit well with the EU.

Italy’s situation reminds me of Greece’s a few years back, when it was thought that Greece would leave the euro and issue their own devalued currency to pay its debts. Most economists felt that this would be a disaster for Greece and lead to capital flight and economic collapse, and I feel the same about Italy today. As the Financial Times put it today, “Any decision to leave the euro would send Italian banks insolvent, as they are big holders of Italian government bonds.” I think the Italian people know this – the Times calls it a “self-impoverishing decision” – and I think cooler heads will prevail.

Having said that, 2-year interest rates in Italy have surged from -0.35% at the beginning of May to 2.5%. With government debt larger than GDP, this would add about 4% of GDP in additional interest costs to service existing debt (Asian Times). So, Italy has to do something, and it needs access to lower borrowing costs while it negotiates some spending/budget reform. But the real point I want to make in this note is that the Italian debt crisis does not pose a threat to the global financial system like the mortgage derivatives did in 2008. Foreign holdings of Italian debt have actually fallen from $900 million in 2010 to $700 million today (Asian Times). That’s million, not billion or trillion.