Will Italy's Debt Monster Scare Up Another Crisis?

Just when it seemed safe not to worry about the next financial crisis, up pops Italy. "In Italy, lavish plans may propel next crisis," warned The New York Times. Or, "Italy's budget rattles financial markets on debt crisis fears," said Sky News.

Exactly how a crisis might emerge isn't clear. Would Italian interest rates soar, reflecting fears that the country can't service its colossal debt? Would Italian banks weaken because their bonds lose value? Would there be spillover effects on other countries? Might Italy abandon the euro?

What is clear is that the new Italian government is flirting with trouble. All the ingredients of a crisis are present.

Consider.

(1) Italy's sovereign debt — that is, its governmental debt — is already massive. It's estimated at 131% of the country's economy (Gross Domestic Product), the second highest among countries in the eurozone. The highest is Greece (nearly 180% of GDP), but Italy's is more worrisome, because its economy is the third largest in the eurozone, behind Germany's and France's. Italy's economy is roughly 10 times the size of Greece's, says economist Desmond Lachman of the American Enterprise Institute. Whatever happens, the impact on Europe's economy and financial markets will dwarf the repercussions of the Greek crisis.

(2) Italy's economic growth is almost non-existent. Since 2010, it has averaged less than 0.2% annually, reports the International Monetary Fund. This is important. If countries are growing rapidly, borrowers can repay their loans more easily, because their incomes — wages, salaries, profits — are also growing rapidly. Virtually all advanced countries have experienced economic slowdowns. But Italy is an extreme case. The fact that its growth is near a standstill means the country is highly vulnerable to anything that raises its debt or reduces its growth.

(3) Italy's new government proposes expanding its budget deficit, from 0.8% of GDP — what the previous government proposed — to 2.4% of GDP. There's a collision between what financial markets want (lower deficits) and what Italy's government wants (new policies to satisfy its supporters). The coalition government consists of the populist-left Five Star party and the populist-right League Party. They are committed to a guaranteed "universal basic income" for the unemployed, tax cuts and a rollback of increases in the retirement age.

At the least, Italy and the European Commission — the Brussels-based bureaucracy that oversees the European Union's laws and regulations — seem destined to collide, because the proposed 2019 budget violates European Union rules calling for much lower debt levels. The question is whether the dispute ends in an acceptable compromise or triggers a major confrontation.

"This budget doesn't make the Italian debt sustainable," says Jeromin Zettelmeyer, a former top German economic official now at the Peterson Institute in Washington. "The worry is about a political standoff. The government could ignore requests of the European Commission (for budget changes)." But so far, he notes, "there is no panic in the markets," suggesting that investors believe an accommodation will be reached.

The larger issue is why the Italian economy has bogged down in recent decades. As Bill Emmott, a former editor of The Economist, noted in his book "Good Italy, Bad Italy," this wasn't always the case. From 1950 to 1970, Italy's GDP grew an average of 5.8% a year — a rate that, even if halved now, would still make sizable debt reduction possible.

To some extent, an economic slowdown was inevitable. There was a long period after World War II of "economic catchup" as Italy and many countries rebuilt and adopted existing technologies. But more recently, Emmott argues, over-regulation and chronic budget deficits have sapped Italy's economic vitality.

Italy's debt has become an economic and political monster. What's ultimately at stake is whether the monster can be controlled inside of Italy or whether it breaks out, spreading havoc across global economies and financial markets.