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Who Wants to Give Italy a Free Loan?

With global financial markets awash in cheap credit, Italy is issuing zero-interest bonds and hoping that it can somehow avoid fiscal calamity.
October 27, 2020
Some people wearing protective masks demonstrate against the government and banks due to the crisis caused by the Coronavirus in Piazza del Duomo on May 04, 2020 in Milan, Italy. Italy will remain on lockdown to stem the transmission of the Coronavirus (Covid-19), slowly easing restrictions. (Photo by Lorenzo Palizzolo/Getty Images)

Every credit binge has a poster child—a bond that encapsulates the misallocation of resources caused by easy money. The last  poster child was the 100-year bond that the Argentine government issued in 2017. The leading candidate to succeed it would seem to be the recently issued Italian government’s zero-interest bond.

In response to the September 2008 Lehman bankruptcy, the world’s major central banks embarked on an unprecedented round of monetary easing, evidenced by a $10 trillion increase in the combined size of their balance sheets. In 2017, at the crest of the ensuing global credit binge, global investors in search of yield fell over themselves to buy a 100-year Argentine government bond.

Never mind that the Argentine government had defaulted five times over the previous 100 years and that the country was, to be generous, not known for sound economic management. For investors, the penny only seemed to drop towards the end of 2019 when the country was forced to impose capital controls and a few months later when it drastically rescheduled its debt.

The world’s major central banks are now responding to the COVID-19 pandemic in a manner that makes their earlier response to the Lehman bankruptcy pale in comparison. As an example, while it took Ben Bernanke’s Federal Reserve seven years to expand the Fed’s balance sheet by more than $3 trillion, Jerome Powell’s Fed has taken less than five months to do the same. This is once again ushering in a period of global financial folly as, in their desperate search for yield, investors are now lending to the most un-creditworthy of borrowers. Last time, that borrower was Argentina. Now, it is Italy, which can borrow at a zero interest rate—a lower rate than even the U.S. government.

However, there is likely to be a major difference between the Argentine bond experience and the prospective Italian bond experience. When reality finally set in and Argentina defaulted on its bonds, there was barely a ripple in world financial markets. With Italy, the world’s third-largest sovereign bond market after the United States and Japan, we are unlikely to be so lucky. Should the country indeed have to restructure its sovereign debt, a major European banking sector crisis with ripples across the world would be the all-too-likely result.

Investors with seemingly short memories of Italy’s 2012 sovereign debt crisis do not seem to be fazed by the fact that Italy is presently experiencing its worst economic recession in the last 90 years, totally undermining the country’s public finances. According to the IMF’s latest estimates, largely as a result of its pandemic-induced recession, Italy’s budget deficit will balloon to 13 percent of GDP in 2020. Meanwhile, by the end of the year its public debt level will skyrocket to more than 160 percent of GDP, the highest level in the country’s history.

Investors also seem to be forgetting that Italy is hemmed in by the Euro, which will once again limit its options to mend its public finances without exacerbating its recession. They are also discounting (or ignoring) the apparent second wave of the pandemic cresting over Italy, threatening a double-dip recession.

In snapping up Italian bonds at ridiculously low yields, investors seem to be making the classic mistake of thinking that this time will be different. Somehow despite Rome being on an unsustainable public debt path, investors are betting that the European Central Bank (ECB) will keep buying enormous quantities of Italian government bonds in the belief that Italy is too big to fail.

It does not seem to have occurred to investors that with a government debt of more than €2.5 trillion, Italy might also be too big for the ECB to bail, especially when another big ECB member like Spain might also need the ECB’s support. Nor do investors seem to be paying much attention to the recent German Constitutional Court’s ructions about the legality of the ECB’s bond buying program, or to the deep divisions that are emerging within the ECB’s governing board over the advisability of further large bond purchases.

U.S. economic policymakers must hope that global investors are right in thinking that Italy can avoid a debt restructuring with all of its unwelcome spillovers to the rest of the global economy. However, hope is not a policy, and officials in the Treasury and the Fed would be well advised to make contingency plans for the overwhelmingly likely outcome that this time will not be different and that Italy’s current borrowing binge too will end in tears.

Desmond Lachman

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.