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Italy’s populist government has failed its first big economic test. The two ruling coalition parties – the League and the Five Star Movement – promised a desperately needed economic revival after they formed a government last June. Instead, they delivered a recession.

Italy needs another recession like it needs Vesuvius to erupt again and bury Naples. The two quarters of back-to-back contractions in the last half of 2018 mark Italy’s third recession since the 2008 financial crisis and there are ample indications that the economic downturn may persist in spite of the government’s dubious assurances that it will be short-lived. On Monday, the Italian purchasing managers’ index (PMI) for January dropped to 48.8 points, which was worse than expected. Any figure below 50 indicates an economy in decline.

The Italian recession is not just an embarrassment for the populist government and devastating news for employers and employees in a country where the youth jobless rate is more than 30 per cent; it’s bad news for the rest of Europe, too. That’s because Italy, the euro zone’s third largest economy, is sitting on outrageous amounts of sovereign debt, much of which is held by Italian and other European banks. An Italian debt crisis – Europe’s nightmare scenario – could severely damage the wider European banking system and wreck the already weak Italian banks.

Italy is often close to the financial precipice because it has a debt-to-gross-domestic-product ratio of 132 per cent – the fattest in Europe, bar Greece’s – a fairly hefty budget deficit and no growth. The economy is still about 5-per-cent smaller than it was before the 2008 financial crisis and, shorn of its national currency, Italy cannot try to devalue its way to prosperity.

In 2011 and 2012, when the yields on Italian sovereign debt were soaring (bond yields and bond prices move in opposite directions), Europe went into a panic. Italian yields at one point punched through 7 per cent, the level that shut Greece, Ireland and Portugal out of the public debt markets, triggering their bailouts.

An Italian bailout was considered unaffordable – think Greece times 10. The European Central Bank came to the rescue. In the summer of 2012, ECB president Mario Draghi promised to do “whatever it takes” to keep the euro intact. In came all sorts of emergency yield-busting techniques, such as the quantitative easing which saw the central bank buy about €350-billion ($526-billion) of Italian debt. Italian yields plunged and the panic was off.

But financial tranquility never lasts long in Italy, which is essentially broke, allergic to economic reform and mills through governments at the rate of roughly one a year. The tranquility shattered in the autumn, when the government went to war with the European Commission, which did not approve of Rome’s lavish spending plans in the proposed budget. The ugly standoff sent Italian bond yields surging again – they reached 3.5 per cent in October – sending shivers through the European banking system. A budget peace agreement brought yields down, but at 2.7 per cent for the benchmark 10-year bonds, they are still exceeded only by Greek bonds. Even Spain can borrow at less than half the cost of Italy.

This is where the banks come in. Most of Italy’s €1.5-trillion mountain of public debt is held by Italian banks. When Italian bond yields go up, and prices fall, those banks become more fragile. No wonder bank bailouts are still fairly common in Italy. But a lot of Italian debt is held outside of Italy. According to data compiled by Bloomberg, French banks had some €285-billion of Italian credit exposure (public and private debt). At €59-billion, German banks had the second greatest Italian exposure. Belgian banks ranked third, with €23-billion, and Spanish banks fourth, with €21-billion.

In other words, an Italian debt crisis is not just Italy’s business; it’s Europe’s. A new crisis could turn all that Italian debt to junk.

There is ample opportunity for a new crisis. The Italian recession could deepen. A new budget battle could erupt between Brussels and Matteo Salvini, the combative deputy prime minister and interior minister who has become the public face of the Euroskeptic government. Italian debt could get downgraded even further – the Moody’s downgrade in October took the debt to the lowest investment grade possible.

Or the Italian government could blow up. The League and the Five Star Movement have been squabbling for months and can’t seem to agree on anything. Lately, they have clashed over whether to approve the proposed high-speed rail link between Lyon, in France and Turin, in Italy, one of the world’s most expensive infrastructure projects. According to the polls, Mr. Salvini and his League party would come out on top in the next election, putting Mr. Salvini, who is probably already Europe’s most powerful Euroskeptic populist, in the prime minister’s office. A fresh battle with Brussels over fiscal restraints would surely erupt, rattling the bond markets once again.

At the same time, the ECB seems to have run short of the will – and means – to fight another debt crisis. Mr. Draghi, whose primary job was to keep the euro zone intact by preventing the collapse of Italy and Greece, is stepping down later this year and his replacement may not be so indulgent with the euro zone’s basket-case Mediterranean economies. At the same time, the ECB’s quantitative easing program is winding down, eventually removing a key price support for the debt.

Europe has a lot of problems. Britain is to leave the European Union next month and could crash out without a deal, spreading economic turmoil. The violent gilets jaunes protests could ramp up again, bringing French cities to a standstill. The Euroskeptic populists might come on strong in May’s EU’s parliamentary elections. And a bank-bashing Italian debt crisis could erupt. Italy is playing a dangerous game just when Europe is looking exceedingly fragile.

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