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Global Economy

Are Italy's public finances faltering?

Vincenzo Visco has seen many storms in Italian fiscal policy. The 80-year-old economist was a university professor and finance minister under Romano Prodi – and is now concerned about developments on the markets after Mario Draghi's fall: "The current situation has a strong political component. The new elections and a possible victory for a radical right are unsettling the markets. This is reflected in the current development of the spread."

The spread is the difference between interest rates for German and Italian government bonds. On the financial markets, it is an important benchmark as to whether Italian public finances are healthy or not. At the beginning of the week, the spread was 2.25 percentage points, around two and a half times higher than in mid-February. For many, this is an alarm signal.

Because at the beginning of the year, the major Dutch bank ING was still saying that a spread of more than two percentage points would send Italy into a financial tailspin due to its high national debt – with all the associated dangers for the euro.

"There are no major problems at the moment"

The Italian analyst and financial book author Maurizio Mazziero, on the other hand, does not see the red warning level being reached: "At the moment there are no major problems. They could arise if the spread rises above three percentage points." The danger beyond the three percent threshold is that you are entering the upper range of what has already been seen in the history of the Italian spread.

Namely in the financial crisis of 2011: At that time, says Mazziero, the Italian spread reached the limit of five percentage points. Currently, the level is more than half lower. In principle, however, the analyst is also concerned about the development of Italian government bonds.

Political uncertainties are driving returns

Since the Draghi government was in crisis, the yield on ten-year bonds has been over three percent. The last time interest rates were higher was almost four years ago, in October 2018. The drivers of the current development are political uncertainty in Italy and the changed interest rate policy of the European Central Bank.

This new interest rate policy tends to be dangerous for Italian public finances, explains Mazziero: "More expenditure on interest rates contributes to increasing debt. The debt then has to be financed in turn." To do this, an ever-increasing amount of government bonds would have to be issued. Which in turn increases debt through higher interest payments, according to the analyst: "You can get into a vicious circle that is very difficult to get out of."

The ECB holds 30 percent of Italy's national debt

However, he also emphasizes that the current threat to Italy's public finances is significantly lower than in the 2011 financial crisis. Firstly, because around a third of Italy's debt has now been bought up by the European Central Bank and is therefore not exposed to market speculation.

Mazziero also sees the new Transmission Protection Instrument (TPI ), against which lawsuits are already being threatened in Germany, as a means of disciplining governments who are willing to spend: "We don't yet know much about the rules by which this instrument is applied. But it's clear that the instrument will only be activated if budgetary policy is balanced, there is no macroeconomic imbalance and, above all, tax policy is stability-oriented."

Inflation benefits the debtor Italy

Inflation is currently playing into the hands of the government in Rome. Like any price increase, it benefits the debtors. Italy's mountain of debt, currently around 2.75 trillion, is melting at least a little these days.

And, even more important for public finances: Italy's economy is growing. While Germany stagnated at zero in the second quarter, Italy recorded growth of 1.0 percent. Former finance minister Visco fears that if the right-wing parties take over government, this development will slip: "If they come into power and, as announced, raise pensions and lower taxes – then it will be painful. Very painful."

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