One of the more underreported stories in recent weeks has been the coalition government taking shape in Italy and how their promises of massive spending increases and the subsequent increases in public debt would blow up the Eurozone.
Italy is no Greece, Its economy is 10 times the size and is already in debt trouble. The populist coalition that is going to take power is eurosceptic and anti-austerity. In other words, the threats from other EU members about sticking to budget targets and putting a ceiling on public debt may be falling on deaf ears.
Arriving for a meeting of euro zone finance ministers, the hawkish Slovak representative went so far as to warn that Italy under its new eurosceptic, anti-austerity coalition risks casting itself adrift from the common currency in a manner that would do severe damage across the bloc.
“I sincerely hope that the new Italian government won’t ignore rules and take euro zone hostage for the sake of pre-election promises,” Peter Kazimir tweeted.
“That would be a very risky business.”
“Should they decide otherwise and go on a ‘suicide mission’ and jump the ship instead, so be it ... but let me be clear, you’re not alone on board of that ship.”
Economists echoed these concerns by openly evoking the possibility of an Italian default if pledges of high spending were carried out by the forthcoming coalition government of the anti-establishment 5-Star and the far-right League.
“If Italy were to follow through on its new plans for spending, the expected reaction among bond-buyers would make it very difficult for Italy to finance its already significant amount of public debt,” the Brussels-based think-tank Bruegel said in a note sent on Thursday.
Following the election surprise in March, where populists and far right parties did well enough to cobble together a coalition government, European bond markets became unsettled. If the coalition follows through on their promises to increase spending - and the already shaky Italian bond market collapses - Europe would be confronted with a catastrophe that not even France and Germany together could fix.
While EU partners are waiting to see exactly what policies a new government under the political unknown Prime Minister-designate Giuseppe Conte will pursue, many see private investors as the first reality test for the ruling coalition.
A policy of increased spending in explicit breach of EU fiscal rules “would likely be met by aggressive Italy underperformance versus other markets”, investment bank J.P. Morgan said in a note for investors.
Borrowing costs for Italy have already spiked in past weeks as the government coalition moved closer to taking shape.
The European Commission also has tools to pressure member states not to let government deficits and public debts rise above set levels but senior officials acknowledge that these have often not been applied strictly - notably to France - and that they may not be strong enough to deter a new Italian government.
The EU will never be able to force Italy to comply with its budget and debt rules. But the market may make their decision for them. There will be no Greek-style bailout for Italy if they default, and the tools available to the European Central Bank will almost certainly not be enough to avoid calamity.
The problem of an Italian collapse would be magnified as the "contagion" spread to much smaller economies in the Eurozone, although many of them would be able to withstand the shock. But if the 4th largest economy in the EU goes belly up, and Italy is forced or voluntarily goes off the euro, it's hard to see how the organization can survive as a united economic bloc.