Another eurozone sovereign debt crisis is inevitable unless the confrontational approach of the European Commission to Italy’s debt problem gives way to greater co-operation. The looming deterioration of Italy’s fiscal position — driven by rising bond yields, slowing growth and eventual recession — and political necessity are setting the stage for further market turbulence. Only the presumption among investors that the European Central Bank will guarantee Italy’s access to international markets is preventing a further rise in yields.

Contrary to widespread prejudice, Italy has been a frugal country. Its debt overhang is a legacy from before it entered the eurozone. Since then it has achieved a primary budget surplus (the excess of revenue over non-interest spending) almost every year. By comparison, all other eurozone countries, with the exception of Germany, have racked up cumulative primary deficits. Italy’s new debt since 2000 has been used to pay interest; it has not financed spending. Plus, the country has also achieved a current account surplus in recent years.

Yet the policy of reducing its debt overhang through restrictive fiscal policy, while simultaneously implementing painful structural reforms to promote growth, has failed. Italy is stagnating. Its economy has grown just 7 per cent during the past two decades, compared with 40 per cent in Spain and 30 per cent in France and Germany.

Meanwhile, its debt has continued to grow. Spending cuts have lowered the standard of living sufficiently to have radicalised the Italian electorate. Reform efforts have stalled because they cannot be implemented at the same time as austerity. Even Germany broke Europe’s deficit limits with its Agenda 2010 reform programme after 2003.

Some argue that Italy’s deficit constraints must be loosened to jump-start the economy. But this will provide only a short-term growth boost. Higher deficits, resulting in higher debt, will push up bond yields, further increasing deficits. Likewise, higher tax burdens on income or wealth to finance additional expenditure will depress growth rates and further alienate the electorate.

Moreover, the political atmosphere in Europe is such that reducing Italy’s debt through mutualisation or direct fiscal transfers is inconceivable. The option of a debt writedown with private sector involvement is also unfeasible.

The only viable option left is to reduce Italy’s debt service payments. This would create room to increase spending to modernise its economy without increasing the deficit and debt. Increased expenditure on infrastructure, and on ensuring that reforms are implemented, will ultimately boost the country’s growth rates from their current anaemic levels. This will also enhance its ability to service debt in the future. Should the economy not grow, then it is inevitable that we will be forced to accept a substantial writedown on Italian debt.

Private investors will not voluntarily agree to postpone debt service payments. So the European Stability Mechanism would have to get involved, funding a repurchase of part of the high-cost debt. Interest on the ESM loan would be payable when Italy’s economy had achieved higher productivity and growth. The ESM would not directly subsidise Italy with a fiscal transfer, although it would significantly increase its balance sheet exposure to the country and its borrowing costs would be likely to increase.

If Italy’s debt service were cut by half, or about two percentage points of gross domestic product, it would be able to increase public expenditure by about €35bn yearly. Involving the ESM in this way would amount to a vote of confidence in Italy’s growth potential and would trigger a significant decline in yields and debt service. The European Central Bank could also use its outright monetary transactions programme to bring yields down to pre-crisis levels.

The outlines of a grand bargain are as follows: Italy has to accept that lasting improvements in growth will not be achieved without structural reforms. Europe, meanwhile, should acknowledge that the solution to the debt overhang is not outright austerity.

If both sides can accept this, then the route to an ESM solution opens up. Some will argue that helping Italy will only encourage profligacy. But its performance over recent decades contradicts this view.