Specter of the Economic ‘Doom Loop’ Is Back as Italy Battles the EU

History suggests that the world is about due for another financial crisis. One of the places it might start, according to a growing number of indicators, is Italy.

Many of the ingredients are there. A pile of questionable debt. Weak banks. An erratic government. And a sizable economy able to inflict collateral damage outside Italian borders.

Bond investors, always good for a coldblooded appraisal of a country’s solvency, have been sounding the alarm. The Rome government’s populist spending plans, widely regarded in financial circles as reckless, have caused market interest rates on Italian debt to spike, threatening to create a so-called doom loop that would ripple through the struggling economy.

The proposed budget has exposed the seams in Italy’s governing coalition, where one party favors small-business friendly tax cuts and the other enormously expensive welfare programs. More broadly, it has divided the populist government, which has vowed to press ahead with a budget it views as a political imperative, and the Italian financial establishment, which fears what the spending will do to the country’s economy and its credibility and relationship with Europe.

You don’t have to be Italian to be worried about the repercussions.

Financial crises tend to arrive every decade or so, and Italy is near the top of a list of flash points that could touch off the next one, alongside Turkey’s economic and political turmoil, President Donald Trump’s trade war, Britain’s exit from the European Union, and a broad slowdown in global growth.

But in contrast to the financial crisis that began in 2008, central banks may not be able to come to the rescue this time, said Richard Portes, a professor of economics at London Business School. They used up much of their resources coping with the last meltdown.

“It would be very difficult for Mario Draghi to think of another way to get out of the mess,” Portes said, referring to the president of the European Central Bank.

That is why investors are so worried about Italy. The eurozone is still recovering from a debt crisis that began in Greece in 2010. Italy, the currency bloc’s third-largest economy, accounts for 11 percent of the European Union’s gross domestic product — 10 times as much as Greece — and has the potential to create far more damage.

Many of the country’s problems are long-standing, such as the unusually high number of problem loans on its banks’ balance sheets and chronically slow growth. Italy’s economy has still not made up the ground it lost after the 2008 financial crisis. The new element is Italy’s populist government, which to the horror of EU officials and bond markets is pledging money it doesn’t have to fulfill campaign promises.

Unlike previous Italian governments that bristled at, but ultimately complied with demands from, the EU, Italy’s populists have made their careers running against Brussels. They are pursuing a brazenly confrontational course with the European Commission, never mind the market reaction or the consequences for Italian savers, who are among the biggest holders of government bonds.

“The enemies of Europe are those barricaded in the bunker of Brussels,” Matteo Salvini, the leader of the anti-immigrant League and the country’s most powerful politician, said this week in a news conference. He has repeatedly called European Commission President Jean-Claude Juncker and Economics Commissioner Pierre Moscovici the villains who “have ruined Europe and our country” through austerity measures.

Under eurozone rules, Italy must submit its budget for European Commission scrutiny by Monday. The proposed spending plan calls for a deficit equal to 2.4 percent of GDP, a figure considered way too high for a country whose total government debt equals 131 percent of GDP, more than double the eurozone limit.

The prior center-left government had proposed a budget with a 0.8 percent deficit, which would have allowed Italy to continue chipping away at its total debt.

A significant portion of the new budget would go toward a broad welfare program, a key campaign promise of the anti-establishment Five Star Movement to its young, unemployed and frustrated base, many in Italy’s depressed south.

“In a decisive manner, with this measure, with this budget, we will have abolished poverty,” Luigi Di Maio, the political leader of the Five Star Movement and Italy’s economic development minister, said last month.

A negative report on the proposed budget by Fitch Ratings on Wednesday night has injected extra anxiety into the budget negotiations. In its report, Fitch cited the “disorderly buildup” to the budget presentation and the disagreement between Five Star and League on fiscal priorities, the lack of detail on tax proposals and the gulf between the “high cost of implementing core policy pledges and the objective to reduce public debt.”

In addition, the hostile tone that the Italians have taken with the EU, the very thing that helped put them in power, “indicates that the government sees political opportunities in attacking the EU’s fiscal rules, especially in the run-up to European parliamentary elections next May,” the report said. Fitch has signaled it could downgrade its rating of Italy’s debt, a step that if matched by other ratings agencies would further raise the government’s cost to borrow.

The government has cut some expenditures, but in categories that further provoke Brussels. For example, Rome has suspended plans to acquire a new missile defense system at a time when Europe is trying to appease Trump by spending more on NATO.

The spending plan was “a significant deviation from the fiscal path” recommended by European leaders and “is therefore a source of serious concern,” Moscovici and Valdis Dombrovskis, the vice president of the European Commission, wrote to the Italian government last week.

Officials in Brussels face a dilemma, though. They will lose credibility if they fail to discipline an errant member. But if they take too hard a line they will simply make Brussels a convenient scapegoat for Italian politicians.

For that reason European leaders are likely to initiate a process that could lead to sanctions, such as cutting off EU funds, but pursue it cautiously. “They will have to do something but they will take their time,” said Grégory Claeys, a research fellow at Bruegel, a think tank in Brussels.

Italy’s government, at least for now, appears popular and immune to electoral pain. When the Italian Parliament passed the budget proposal at the end of September, Di Maio and his allies in the Five Star Movement took to the balcony of the Palazzo Chigi, the seat of Italian government, and flashed victory signs as a crowd of lawmakers and supporters below them chanted “Luigi! Luigi!”

But public support could begin to waver if investors continue to lose confidence in Italian debt, which would have severe consequences for the economy. Italy is still a long way from the darkest days of the eurozone debt crisis in 2011, when investors bid the market rate, or yield, on government bonds to more than 7 percent. But the yield has climbed significantly since the populist government won elections earlier this year, topping 3.7 percent this week compared with 1.7 percent in May.

Italian banks like UniCredit have large holdings of their home country’s debt. When yields rise, the value of their bond holdings goes down, eroding their capital and raising questions about their health. UniCredit shares have slumped to about 12 euros recently from 18 euros in April.

In an effort to preserve capital, banks then become more cautious about lending. Consumers and businesses have to pay higher interest rates to borrow, or might not be able to get credit at all, strangling the economy.

If economic growth slows and unemployment rises, fewer people pay taxes and the government’s financial situation deteriorates further. Investors then insist on a higher risk premium on Italian bonds — a higher return — and the cycle repeats. That’s why it’s called a doom loop.

“Debt is the great multiplier of turbulence for Italy,” Luigi Federico Signorini, the deputy director general of the Bank of Italy, told a parliamentary hearing Tuesday. “Oscillations in its value also have effects on the Italian individuals, families, companies and financial institutions that hold it.”

Polls show that Italians do not want to give up the euro, a fact that may restrain the government. It has shown in the past it would react to pressure, appointing a moderate, Giovanni Tria, as finance minister after objections were raised to the initial choice, Paolo Savona, an economist who had written about exiting the euro. But Tria has been worn down by the lengthy budget negotiations and subjected to humiliating attacks by the leaders of the League and Five Star Movement. In an audio recording leaked to the Italian media, a high-ranking official in the government who is also a prominent member of the Five Star Movement threatened to fire bureaucrats under Tria if they couldn’t find money to get the welfare measure in the budget.

On Tuesday, Claudio Borghi, the president of the budget commission in the Lower House of Parliament who is a member of the euroskeptic League, cut off Tria’s microphone during committee hearings.

Tria has insisted he is not considering resigning.

Provoking Brussels has been a winning political strategy for the current crop of Italian leaders, and they show no signs of giving it up.

“We care about markets,” Di Maio said last week. But faced with a choice between bond yields and the Italian people, he added, “I choose the Italian people.”