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How Will the EU Handle Italy's Debt?

The New Year has come with an unexpected slowdown in the markets amid the covid-19 outbreak in the Wuhan province of China. Although markets have recovered considerably since then, there are some major challenges lying ahead for the global financial market. Most market outlooks focus on the hot topics like the trade wars, the aftermath of Brexit, and the ability of central banks to control debt. However, there is a bigger threat lurking for the Eurozone.

In 2002, the Eurozone definitively introduced the Euro as the sole currency for 19 of its 28 nations. The idea behind the concept was to enhance trade and stability in the region. But this leads to the destruction of the balancing factor between northern and southern Europe. When debt levels grew after the global financial crisis of 2009, the Eurozone was hit by a deep recession by 2011 with high unemployment rates. This led to a high debt-to-GDP ratio for many Euro nations. While many analysts are comfortable with the handling of the debt crises of Greece by the Eurozone, it is pertinent to mention that the nominal debt of Greece is much smaller than those Italy, Spain, and Germany. Italy’s €2.4 trillion debt is about 135% of its GDP and 27% of the total debt of the Eurozone. Hence, the currency which was meant to solve the problems like debt is actually causing them.

Italy’s debt hasn't just piled up in a few years. It has been growing steadily since 1999 at which point it was less than 90% of its GDP. The reason behind the sharp increase in the debt-to-GDP ratio since 2008 is the poor performance of the Italian economy.

One possible solution to this problem of Italy's debt, along with many other Eurozone nations, could be a further integrated EU. This means a Federal Europe with a common budget and Eurobonds, which could effectively distribute the income, liabilities and wealth of all EU nations. This could potentially solve Italy's financial problems, as well as the other debt-driven economies of the Eurozone. However, strong economic countries like Germany, which have a low debt-to-GDP ratio, would fiercely oppose this. So if it comes to a situation where the EU plans to bail out Italy, this could be the breaking point. It will likely cause panic on both sides. Italy would see this as the fiscal tightening due to sanctions put on the country and the citizens of strong EU countries like Germans would not want to bail Italy out. Another possible way to handle this is through market forces. But considering the size of Italy’s debt, this is also almost impossible to deliver.

Italy’s politics also affect this problem. The increasing sentiment towards nationalistic politics is a major factor that has to be considered. We have seen the political parties fight on both the nationalistic and pro-EU lines since the last decade. The EU will need the pro-Eurozone party in charge if they intend to address Italy’s debt crises. Another potential outcome would be Italy's withdrawal from the EU. This could be the most realistic outcome possible, as there isn’t any other solution that would be acceptable to all parties involved.  If the EU wants to keep Italy, they would have to offer something positive to Italy along with the bailout plan. But if they implement discipline only, it may result in worsening already out of control situation.