Bond yields would soar. The banks would be in trouble. Businesses would be starved of cash, and money would start to flee the country. Pretty soon, the "doom loop" would kick in. With the financial system facing a meltdown, Italy's "populist" government would back down on its extravagant election promises, tone down its rhetoric, and do what the EU tells it to.
That, at least, was the script from Brussels when the Northern League and Five-Star Movement took power in Italy earlier this year. Yet Italy decided to increase spending regardless, in defiance of the rules that bind it into the euro. European Commission president Jean-Claude Juncker sent the government warning letters. "The only letters I accept are from Santa Claus," responded Matteo Salvini, Italy's interior minister and leader of the Northern League.
A problem with the script
The bond vigilantes aren't following the script, either. The financial markets are either not able, or not willing, to do Brussels' work for it. Perhaps that's not so surprising. By the standards of the past decade, the budget put forward by the Italian government was hardly that radical. Some tax reductions and increased spending would push the deficit up to 2.4% of GDP. Only a few years ago countries such as the UK were running deficits of 10% of GDP. So 2.4% hardly seems like the end of the world. Even so, the rules of the single currency demand that members don't run excessive deficits. The commission insisted Italy come back with a new plan.
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Understandably, the government refused, and it is now threatened with sanctions if it does not obey. The truth is that a fine here or there is not going to matter very much. But national bankruptcy is scary for any government, and should force a change of policy. Italy has debts of €2.1trn or 131% of GDP. It has to pay billions of interest on that mountain of money every year, and roll it over as it falls due for repayment. Any significant rise in the cost of borrowing, or threats to lock it out of the capital markets, would quickly bring it to its knees. That is what happened when Greece defied the EU, and in 2011 when Silvio Berlusconi was replaced by the pro-EU technocrat Mario Monti. Sooner or later the populists are bought tamely to heel, and the crisis is over.
Except that isn't quite happening this time. Italian bond yields have risen and bank shares fallen. But hardly catastrophically so. There is no real pressure on the government to buckle. Why is that?
The first reason is that a mildly expansionary budget is perfectly sensible for Italy. This is a country that has hardly grown in the two decades since it signed up to the euro. In the latest quarter, it slipped back to zero growth and is only a whisker away from a recession. It has high levels of unemployment, and plenty of slack in its economy. You hardly have to be John Maynard Keynes to conclude a little extra government spending might be appropriate this year. It is the EU's insistence on yet more austerity that looks extreme.
Too big to fail
Next, the rules have changed. In the last euro crisis, it was not clear whether the European Central Bank would step in. Investors faced a real danger of default on Greek or Italian bonds. So it was hardly a great surprise that yields soared. With the central bank now printing trillions of euros, that seems far less likely now.
Finally, Italy is too big to fail. Its debts could bring down the banking system across Europe and potentially trigger the collapse of the single currency. The markets know that and so won't do the EU's work for it as they did in 2011 and 2012.
Over the next few weeks the Italian government may well be fined €3bn-€4bn. But it won't be locked out of the debt markets, and the banks won't collapse. It will sail on as if nothing had happened. That is going to turn into a big problem for Brussels. It won't be long before the Greeks, the Spanish and indeed the French notice that you can defy Brussels as much as you want to and there is not much it can do about it.
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Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years.
He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.
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