The sheer scale of Italy's debt threatens global GDP

LONDON — The debt Italy owes to the rest of Europe — 25% of its GDP — is so bad that a default would "shatter" the country, cripple Europe with unpaid debts, and wipe 0.4% off global GDP, according to Oxford Economics analyst Taha Saei.

"If the Eurozone’s fourth largest economy were forced to leave ... the euro, it would likely default given the increased debt obligations from settling this bill would cripple its economy," Saei says.

Recovery would take decades, he wrote in a recent note to clients.

Italy's populist 5 Star Movement (M5S) has proposed abandoning the euro as a currency in order to reboot the economy by launching a competitively devalued new lira against the euro. M5S, led by Beppe Grillo, has made gains in Italian polls over the last few years, as the Italian economy has stagnated.

Italy's current debt is €430 billion ($495 billion), and getting worse: That has led M5S supporters to wonder whether crashing out of the euro might be Italy's best bet.

After all, the alternative is to stay on the same road as Greece. Greece has yet to recover from a recession that is statistically worse than the Great Depression in the US. Athens is stuck paying billions back to the European Central Bank even though its economy is too small to handle them, requiring a never-ending series of "restructuring" agreements. The country is trapped in an impossible cycle: Greece needs to grow in order to pay its debt. But its debt siphons off the cash it needs for investment, crippling its growth.

Italy is beginning to look a lot like Greece: economically moribund, and saddled with debts it cannot pay. That makes an "Italexit" from the euro increasingly appetising for the populists, who say: Don't do the Greek thing! Instead, drop out of the euro, default on the debt, and start again. A short, sharp, shock, followed by a clear path to recovery.

Saei paints a grim picture of that scenario.

He starts with this: "Italy owes the ECB €430bn, the equivalent of 25% of nominal GDP." If Italy left the euro it would be required to settle its debts instantly. "The increased debt obligations from settling this bill would cripple its economy," Saei says.

Italy would thus be incentivised to default, and walk away.

Immediately, the Italian default would transmit back into the European Central Bank. The ECB would apportion Italy's debts among its remaining members. That would add debt at a rate of 5% to 10% of GDP to every other eurozone country. Here's how it would look: Note, for example, that Greece's share of Italian debt is equivalent to another 8% of its GDP. (Greek debt is currently 179% of GDP.)

The default would force a recapitalisation of the ECB. That might suck up the equivalent of 4% of European GDP, Saei says:

"The ECB could absorb some of the losses using its provisions and revaluation accounts, while remaining losses would be carried forward. However, given the central bank’s profits are typically in the region of €1-2bn a year, these deferred losses (as much as 4% of non-Italy-Eurozone GDP) would take decades to recover. Faced with the prospect of a prolonged period of an impaired balance sheet, we believe the ECB would need to be recapitalised to maintain confidence in the euro as a means of payment."

With the 8th largest economy in the world ravaged by self-imposed inflation, and Europe in recession as a result, the knock-on effects would proceed from there. It might ultimately wipe 0.4% from the global economy, Saei estimates. That doesn't sound like much but it could be enough to push planet-wide growth under 2%, a range last seen during the great financial crisis of 2008: