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The Debt Threat - Part 2

In part 2 of our mini-series on the debt threat to the world economy we look at systemic risks in the Euro-zone.

The conventional wisdom is that the euro crisis won’t return. The euro crisis was brought under control when the ECB committed itself to huge bond market purchases. Moreover, the vital signs with regard to a potential crisis, are very different now as compared to before. Bond yields and implied risk from credit default rates are lower. But this doesn’t mean the threat of a return of the euro crisis has disappeared. There remain deep concerns regarding the Italian banking system and the scale of non-performing loans.

Nominal GDP in Italy is around 25 percent below trend. This has given rise to the so-called Italian Death Cross chart, with nominal GDP relative to trend falling, and bank bad debt rising. When nominal GDP is this far below trend, banking sector difficulties are almost a given. The Economist recently ran with a leader article entitled, The Italian Job, which argued that, “At best Italy’s weak banks will throttle the country’s growth; at worst, some will go bust”.The consequences of banks going bust, and the so-called sovereign-bank loop are frightening. This is a scenario where the banking system begins to implode due to the interrelationships between banks, and an already highly indebted public sector moves into much deeper deficit, driving up bond yields and undermining bank capital even more.

On top of this, and potentially interacting with it, Italy faces a third decade of lost growth, having grown very little in the 2000s and 2010s, and now facing a demographic implosion that could undermine growth in the 2020s. The consequences for existing political and economic institutions could be grave, with euro exit an increasing possibility. Ambrose Evans-Pritchard, writing in The Daily Telegraph, has written that Italy leaving the euro “may be the only way to avert a catastrophic deindustrialization of the country before it is too late.”

The domino effect would then kick-in. Wolfgang Munchau, writing in The Financial Times, has stated that: “An Italian exit from the single currency would trigger the total collapse of the euro-zone within a very short period. It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash”.

This is a scary story, but it’s also been one that has been told many times over recent years and has still failed to come to pass. Many economists, including myself, have cried wolf on this before and been proven incorrect.