The world economy has finally recovered from the Global Financial Crisis (GFC), which started in the US in 2007.

It’s been a painful process. Many people lost their jobs or defaulted on their mortgages. Some financial institutions failed and had to be bailed out. Governments were forced into a massive borrowing spree to cushion the blow.

However, after a long recession, the world is mostly back to normal.

Luigi Di Maio, leader of Italy’s Five Star Movement.

The euro is the problem

The eurozone is the main exception. It’s not fully healed because its key problem is the euro itself.

Since 1999, many countries with quite different economies have shared the same currency but have been unwilling to share other economic policies, including government spending and taxation, and bank regulation. As long as that’s the case, there’s a risk that imbalances will build up and trigger a fresh financial crisis.

The eurozone crisis sent shockwaves around global financial markets in 2010, when investors feared that the Greek government would default on its debt and perhaps Greece would be forced out of the single-currency area.

The markets are now less concerned about Greece. This is partly because its economy has, finally, achieved a bit of growth. Also, banks and other financial institutions in the rest of the eurozone have largely cut their financial ties to Greece, meaning that Greece’s problems are less of a worry for the eurozone as a whole.

Debt levels rise in Italy

The spotlight has now turned to Italy. Despite years of austerity measures, Italy’s public-debt burden has continued rising. In fact, it has the third-largest debt levels in the world, after the US and Japan. At 130 per cent of gross domestic product (GDP), Italy’s debt is more than twice the maximum amount recommended for countries to qualify to join the eurozone.

On top of that, Italy’s economy has grown by a measly 8 per cent in the two decades since the euro was created. Compare that to the economies of France and Germany, which have each grown by around 40 per cent.

Euro-sceptics called for Italy to exit

The success of two populist parties in the Italian general election in March brought these concerns to a head.

Leaders of the Five Star Movement and the League have now formed a government. In the past, these anti-establishment parties have called for Italy to leave the eurozone and recreate an Italian currency.

And despite the country’s heavy debt burden, they’ve pushed for a big increase in government spending, as well as generous tax cuts. This has worried investors in Italy’s government bonds, and it led to a sharp rise in borrowing costs in May.

The two parties have since changed tack and pledged to keep Italy in the single currency and the European Union (EU). But their earlier policies can’t easily be forgotten.

One crumb of comfort is that the Italian situation didn’t spread to other government-bond markets this year. Italy’s borrowing costs rose by nearly 1.5 per cent in May, but Spain’s remained much lower. In contrast, when Greece’s status in the eurozone was in doubt, the fear was that other countries would be forced out too.

Trouble may be brewing

The Italian government’s U-turn suggests that there’s not an imminent risk of a crisis. But its government is on a collision course with Germany and the European Commission over migration policy, fiscal policy, and any future integration of the EU itself.

What’s more, the government could fall. After all, Italy has had 67 governments since World War Two. And opinion polls suggest that its next government could be even more hostile towards the rest of the EU.

The fact that Italy’s economy is eight times the size of Greece’s makes it a bigger headache. Indeed, Italy may be ‘too big to fail’, meaning that the stronger members of the euro-currency area, notably Germany, cannot afford to let Italy default or leave the bloc. The economic fallout for Germany itself would be too large.

But equally, Italy may be ‘too big to save’. The governments of Germany and France may be wary of opposition from their electorates if they ride to Italy’s rescue, because potentially the costs would be huge.

Dominoes or one of a kind?

Italy could still pose a very big problem for the eurozone. If it left, investors and the general public might start asking who’ll be next.

Italy could be the first domino of many to fall. And the euro itself, which is approaching its 20th birthday, might disappear. Even if that were to be a good thing in the long run, it would cause a huge amount of chaos in the meantime.

The fallout could spread to the rest of the world. But thankfully, Italy accounts for less than 2 per cent of the global economy, so its domestic problems do not drag down other countries very much. But a crisis in the eurozone would certainly dampen growth and business confidence around the world.

Definitions

Austerity: Government policies that are intended to reduce debt levels through reduced public spending or increased taxes.

Eurozone: Countries that are part of the European Union and have the euro as their currency.

Gross domestic product (GDP): GDP is a measure of a country’s market value. It covers all goods and services produced within a timeframe and can be used to compare nations.

View JUNO's full list of definitions here.

First published 20 August, 2018.

Story by Andrew Kenningham, Capital Economics

JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions. This story reflects the views of the contributor only. Content comes from sources that JUNO considers accurate, but we do not guarantee that the content is accurate.