Is another global financial crisis on the horizon?

Investors are increasingly worried that an escalating political crisis in Italy could lead to a populist, euroskeptic government taking power. As a result, there's rising uncertainty about whether the country might eventually abandon the euro currency zone or default on its giant debt pile. To make things worse, the Trump administration continues to toy with the idea of a trade war with Europe and China. That would be the last thing the global economy would need if the Italian situation deteriorates further. Debt crises and trade wars are a toxic combination.

To fully understand the risk, it's helpful to recall that before there was a Brexit, there was the threat of Grexit. There was widespread concern a few years ago that Greece's government debt crisis would force it to exit the eurozone, and that such a shock departure would be a crushing blow to both the broader European economy, in the middle of recession, and the American economy, which was still recovering from its own downturn.

These fears prompted what is perhaps the most amazing — albeit apocalyptic — research note ever published by a major Wall Street bank or investment firm. In December 2011, Citigroup clients were treated to dark speculation by the firm's chief economist, Willem Buiter, on what might happen if Greece's departure led to a daisy chain of eurozone exits and the eventual collapse of the European Union:

A breakup of the euro area [currency zone] would be rather like the movie War of the Roses version of a divorce: disruptive, destructive, and without any winners. ... If Spain and Italy were to exit, there would be a collapse of systemically important financial institutions throughout the European Union and North America and years of global depression. ... Even if the breakup does not destroy the EU completely and does not represent a prelude to a return to the intra-European national and regional hostilities, including civil wars and wars, that were the bread and butter of European history between the fall of the Roman empire and the gradual emergence of the European Union from the ashes of two made-in-Europe world wars, the case for keeping the euro area show on the road would seem to be a strong one: financially, economically, and politically, including geopolitically. [Willem Buiter, Citigroup]

So, yeah, pretty much everything other than pestilence, famine, and zombies roaming through Manhattan. Now generally, Wall Street research doesn't read like the Book of Revelations or a dystopian alt-history novel. But Citigroup was hardly the only financial player pondering the worst.

Thankfully, the worst didn't happen. Europe muddled through thanks to a combination of Greek debt bailouts and massive money printing by the European Central Bank. But Italy poses a far bigger threat than Greece ever did.

Italy is the eurozone's third-largest economy, 10 times the size of Greece's. It also has the world's third-largest sovereign debt market, some $2.7 trillion. Only Greece has a higher public debt-to-GDP ratio in the eurozone. My AEI colleague Desmond Lachman, a former International Monetary Fund official and Wall Street emerging market strategist, argues that Italy's troubles have the potential to roil the global economy much like the 2008 Lehman bankruptcy. (The 10th anniversary of "Free Market Day" is coming!) America wouldn't be spared.

That's just one of the problems with Donald Trump's America First worldview. It ignores how America is deeply and irreversibly enmeshed in the global economy through linkages we probably don't fully understand, as the original global financial crisis of 2008 showed.

Italy is a mess. It's too big to fail, but also too big to bail out. To a large extent, it will need to save itself though economic reforms that boost its lagging productivity and reduce its debt load as a share of the economy. And America cannot simply sit idly by and pretend that this is not our problem.

Unfortunately, the Italian populists — much like America's — are promising a budget-busting economic fantasy if elected, including a universal minimum income guaranteed to all citizens and a flat income tax. Such a large dose of debt-financed fiscal stimulus, Goldman Sachs warns, threatens the nation's debt rating, the nation's banking system, support from the European Central Bank, and "could eventually call into question Italy's participation in the euro area [with] possible spillovers to other countries."

Italy must get its financial house in order. But America also has a role to play, such as avoiding trade disputes with Europe or China that will exacerbate market tension and potentially weaken global growth. There is little evidence that any of the trade actions currently being contemplated by Team Trump would have much impact on economic or job growth. But a second global financial crisis surely would.