Mario Draghi: Deus Ex Machina or Knight of the Apocalypse?
Servicing Italian debt has never been so cheap. Interest expenditure is lower today than in 2007, when debt was €1 trillion smaller. Does this mean that the scarecrow of European financial markets, Italian debt sustainability, has flown away?
The answer is yes, for now. Looking ahead, though, it depends on how successful Mario Draghi’s new government may be at introducing reforms that boost productivity enough to allow Italy to outgrow its debts. Draghi’s predecessors have tried this before without success, but he has a better chance than they did. He is off to a good start with a political coalition that may keep him in power through 2023, but he will really need to deliver on education, taxes and public administration reforms to help the country turn the corner.
Italy has the European Central Bank to thank for its debt sustainability; the ECB’s asset purchase programme is estimated to have cut longer-term rates by 150 basis points. Having pushed bond yields this low to support those sectors and countries most hit by the pandemic, the ECB is ensuring a rebound in growth in the years ahead. This will make it easy for economic growth to generate the income necessary to pay the debt bill.
Good news about a strong recovery in the euro area might brighten the Italian horizon, but that in itself will not be enough. There are two overall scenarios: either growth for Italy and the euro area accelerates in a similar fashion, or the two diverge, making the job of setting one monetary policy for the whole, single currency increasingly hard. Let’s analyze the second, downside scenario first.
1) Stuck in the Status Quo…
Examining Italian debt sustainability over the medium term shows that, if the unprecedented fiscal accommodation gets growth and inflation quickly above pre-COVID averages but does not increase Italy’s productivity, so that the country keeps growing much slower than the rest of the euro area, the ECB could find itself in an uncomfortable position. It would have to consider withdrawing the necessary support to the Italian bond market, without growth being strong enough to reassure investors that the bond market can walk without the ECB stick.
