Is Italy too big to fail?

In 2008, the US Government and the Federal Reserve decided that the investment banks Bear Stearns and Merrill Lynch were ‘too big to fail’ and pressured, and then assisted other banks to buy them. That is where Federal authorities drew the line defining which US banks were ‘too big to fail’ stopped. As a result, the next troubled investment bank (Lehman Brothers) went into bankruptcy on 15 September 2008, mainly because its problems were seen to be self-inflicted, which triggered panic in global financial markets and resulted in more than USD1 trillion direct US government spending by way of bond, asset and share purchases and emergency loans.

The European Union (EU), European Central Bank (ECB) and European governments are now faced with deciding where to draw their ‘too big to fail’ line. Italy, already in economic recession, has gone into lockdown and will undoubtedly face economic contraction (negative GDP) in many, if not all quarters, of 2020.

The Italian government has announced fiscal support and is promising more, which will exacerbate Italy’s already burdensome fiscal deficit and debt positions and cause it to break the EU’s budget deficit rules. EU and ECB policymakers will have a very important decision to make about which side of the ‘too big to fail’ line Italy sits.

Do they change the EU’s fiscal rules to give troubled all EU nations greater deficit and borrowing capacities?

Do they increase the ECB’s asset purchase (bond buying) programme, and head down the same path as the Bank of Japan, Federal Reserve or Bank of England?

Do they decide that Italy is ‘too big to fail’ and offer a bail out (with possible IMF help) subject to Italy first undertaking fiscal austerity measures, like they did with Greece in 2010? In that case, where do they draw the line on bail outs?

Italy is much bigger than Greece. The consequences of making the wrong choice are potentially enormously dire. Even the long term right choice might have dramatic consequences in the short term. If the Italian government was to default on its debt, just as Lebanon has done this month, the impact on global bond markets and the euro would be devastating.

Italy is the third largest government bond issuer, behind the US and Japan. Yields on Italian government bonds have risen this month, contrary to all other industrialised nations’ government bond yields that have fallen dramatically. Most industrialised nations have two market levers (or circuit breaks) – the exchange rate and domestic interest rates (bond yields). However, Eurozone nations do not have an exchange rate lever – an Italian euro will forever equal a German, French or Dutch euro. So, financial markets have to rely on the interest rate lever to undertake all the risk pricing adjustments.

It seems likely that Italy will be deemed ‘too big to fail’, unlike Lebanon. But what will be the cost? To Europe? To the rest of the world? To business confidence? To jobs? To household confidence and spending? To investor preferences?

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