Next week will be 10 years to the day since the eurozone debt crisis ended, but no champagne corks will pop as the anniversary may very well mark the start of a new one.
At the heart of the drama sits Mario Draghi, the prime minister of Italy who, in his previous role as European Central Bank president, saved Europe’s currency union from annihilation a decade ago.
Late on Wednesday, three of his largest coalition partners walked out after refusing to back his reform agenda. In so doing they effectively ended their 18-month marriage of conveniences, bringing down Draghi’s government of national unity just two weeks after the region was rocked by news his U.K. colleague, Boris Johnson, was forced to resign.
Draghi and his coalition partners couldn’t have picked a worse time to trigger a crisis in Europe’s second most indebted country.
Fuel stocks are running low as Russia wages a war on the EU’s eastern border that is choking off supply — with rationing for businesses this winter a clear possibility. Investors have also been voting against the euro with their feet, sending it tumbling to a two-decade low against the dollar.
“On this day of madness, Parliament decides to act against Italy,” wrote Enrico Letta, the leader of the center-left Democratic Party that supported Draghi until the bitter end. EU economy commissioner and native Italian Paolo Gentiloni blasted the walkout of the three governing parties as the “perfect storm”.
In a continent believed to be drifting into recession, Italy is widely considered to be the ticking time bomb, with debt running at a hefty 150% of gross domestic product. And a new far-right leader hostile to Europe, Giorgia Meloni, potentially beckons as the country’s next leader.
“The dangers for the eurozone are all too real,” wrote Nouriel Roubini, an economist famous for predicting the subprime crisis. “Italy is one focus of concern with its low potential growth, large deficits and enormous public debt.”
‘Whatever it takes’
The formal collapse of Draghi’s government on Thursday now threatens to put his previous employer, the European Central Bank, in a precarious position.
Saddled with €2.7 trillion ($2.7 trillion) in liabilities at the start of this year, Italy owes investors more money than much larger Germany. Pressure will inevitably mount for the ECB to play firefighter by jumping in as the buyer of last resort and funding government expenditure with freshly minted euros. Since this risks violating EU treaties, it may very well prompt yet another legal challenge in Germany’s constitutional court.
Robin Brooks, chief economist at the Institute of International Finance, predicts the ECB would have little choice but to take the path of least resistance and bail out countries like Italy.
“Who wants a repeat of the 2011/12 debt crisis after all?” wrote the former Goldman Sachs foreign exchange strategist.
Berenberg Bank’s top economist, Holger Schmieding agreed: “Unless a potential new Italian government were to pursue decidedly anti-EU or anti-euro policies, which seems unlikely, Italy would be supported if need be.”
Ironically, it was Draghi in his previous role as head of the ECB who rescued the euro from collapse, buying his country precious time to fix its troubled banking system and reform an uncompetitive economy that has barely grown since the introduction of the single currency in 1999.
A decade ago, bond market vigilantes were busy dumping Italian treasury notes, known as BTPs, thus widening the “spread” or premium investors charge Rome to hold its sovereign debt over ultra-safe German bunds. Spain, Greece and other highly indebted countries also found themselves under attack.
The message financial markets sent at the time was simple: centrifugal forces between the diverse ethnic nations would tear Europe apart and doom the single currency. In their estimation, the fiscally prudent northerners would never agree to rescue all their profligate neighbors in the south with fiscal transfers.
Italy’s cost of borrowing became prohibitively expensive, rising to unsustainable levels that already caused the small state of Greece to seek refuge in a coordinated EU bailout. As the third largest economy in the euro area, however, Italy is considered too big to bail.
It was Draghi who saved the day in 2012. With his July 26th promise to do “whatever it takes” to protect the euro, he signaled that the ECB would step in with its unlimited firing power and be the buyer of last resort for sovereign debt. So long as a euro area member chose the path of necessary but painful economic reforms, the bank stood ready to backstop government spending.
Those magic words saved the euro. From then on, no investor dared test his resolve, and the instrument he unveiled called Outright Monetary Transactions (OMT) never even had to be taken out of the toolbox—its very existence sufficed for bond market vigilantes to lay down their arms and surrender without a single shot fired.
Years later when Italy looked for a political figure that could unite the fractious and disparate parties in Rome, they turned to “Super Mario” as he had come to be known.
He set about restructuring the ailing banking system, attempting to pair weak lenders together with stronger ones and drove a campaign to repair balance sheets weighed down by non-performing loans.
“Through his stature, Mario Draghi has been able to create a sense of unity that was previously unimaginable,” the head of Italian supercar manufacturer Lamborghini, Stefan Winkelmann, told Fortune last September. “Naturally parties campaign and attack each other in talk shows, but so far no one has questioned Draghi’s leadership. He’s a beacon.”
‘Making a big mistake’
Four weeks ago, however, bund-BTP spreads once again began to expand just like they had a decade earlier, as bond market vigilantes returned to bet the fiscal strains of the pandemic were proving too much for countries like Italy.
Euro area debt-to-GDP currently stands at a whopping 95.6%, with Italy posting the second highest ratio after Greece—thus making it the second most exposed to rising interest rates by an inflation-fighting central bank. Unlike the United States, whose liabilities already well exceed its annual economic output, euro area members cannot print their way out of a solvency crisis since they relinquished that power to the ECB.
Draghi’s successor as the head of the institution, Christine Lagarde, swiftly convened an emergency meeting in mid-June that decided on a new “anti-fragmentation instrument” expected to backstop Italian debt and reduce diverging spreads.
Quizzed on the specifics last month by EU parliamentarians, ECB chief Lagarde repeatedly refused to show her cards, instead limiting her comments on the instrument to vague outlines.
“It will be effective, it will be proportionate, it will be within our mandate,” she said. “And anybody who doubts that determination will be making a big mistake.”
She justified this new weapon by arguing that the eurzone had been suffering from ‘fragmentation of monetary policy transmission’—in other words the ECB rate decisions were not properly reflected in prevailing credit conditions.
The pandemic left behind deep, uneven scars across Europe’s economic landscape that prevented its policies from filtering through the financial system, according to Lagarde. This argument could now be in danger, however, because the crisis in Rome rips away her legal fig leaf.
“The ECB aims to target ‘unwarranted’ spread widening and likely would not want to be seen to cushion rising government bond spreads triggered by political turmoil,” wrote UBS economist Felix Hüfner.
This Thursday the ECB’s policy-setting body hiked rates by a surprise half percentage point to combat historically high inflation, but the real focus is on its new weapon in the fight against the euro area’s centrifugal forces—now renamed the Transmission Protection Instrument (TPI). Details are due later today.
“Let’s say Italy goes into another political crisis like in 2018 and the spread on 10-year BTPs over Bunds rises,” wrote the IIF’s Brooks. “Will that be considered fragmentation of monetary policy transmission or a justified rise in the risk premium?”
Markets believe the guardian of the single currency may not impose the same kind of conditionality on economic reforms that was a key feature of OMT. This could pose a moral hazard that encourages other countries to act irresponsibly, laying the foundation for bigger problems down the line.
In that famous July 2012 speech that ended a crisis of confidence in the euro, Draghi likened the currency shared by 19 different nations to a bumblebee. The problem, as he saw it, was that financial markets stopped viewing the euro as “a mystery of nature because it shouldn’t fly but instead it does.”
After restoring that very belief 10 years ago, his failure to hold together Italy’s fractious government is putting this faith to the test once more.
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