It has been an eventful few weeks in Europe. Markets have been actively following the unfolding situation in Italy, as the new 5 Star-Lega coalition of populist parties took office. Things have quietened down as the members of the new government have reassured investors that it has no intention of leaving the euro, or breaking EU-mandated public spending limits that might have led to the same event.
But this is not the end of the story because there are a range of possible events stemming from Italy that could unnerve markets in the coming months and test the political foundations of the eurozone.
The bold macroeconomic policies of the new Italian government are the central issue, and will create headaches in Europe. The recently agreed 5 Star-Lega populist administration has plans to sharply increase benefits to the unemployed, radically cut taxes, reduce the retirement age, and increase infrastructure spending. Independent estimates put the increase in spending at over €100bn per year, or 6% of GDP.
Italy is not a profligate country. It has run a primary budget surplus since 1992 and only has overall budget deficits due to the interest charges on its extremely large public debts – currently around 130% of GDP. Much of that debt accrued in the 1970s and 1980s as Italy raised funds to develop its welfare state and to invest in the country’s poorer and more agricultural south through the Cassa per il Mezzogiorno programme. Interest rates also rose sharply in the 1980s as the Bank of Italy clamped down on high inflation, raising the debt burden further.
There are two short-to-medium term problems with the new government’s fiscal plans, the first exists irrespective of whether one believes bigger deficits would lead to the growth and additional tax revenues that would make the new debt sustainable. But both problems potentially lead to conflict between Italy and Europe’s creditor nations such as Germany and the Netherlands.
The first issue is both legal and political. Under the EU’s Fiscal Compact, countries cannot run a budget deficit greater than 3% of GDP, and if they insist on doing so they forfeit the right to assistance from the European Stability Mechanism in times of crisis. Being told by Europe that Italy cannot implement its economic policies is unlikely to reduce populist feeling in the country. Lega’s Matteo Salvini recently said that Italy will not be “slaves of Brussels or Berlin”, while 5-Star’s leader Luigi Di Maio suggested that he will go to “European tables” to fund his spending plans. That means either ignoring or revoking the Fiscal Compact.
The second issue is practical. Running large deficits means issuing quantities of bonds into the market at a time when the central bank is not an active player on the demand side and when interest rates are rising. Italy then would become exposed to significant political risk that could sharply push up yields further and thus the cost of borrowing. That in turn makes servicing Italy’s enormous debt pile even harder and could create centrifugal forces that make the state’s position in the euro area unsustainable. It is the feared ‘debt-crisis’ scenario.
This second issue assumes that markets believe that more state spending would not boost growth, and thus cut the debt-to-GDP ratio in the long-term; that is open for debate. But it also assumes that there are no meaningful political reforms in the euro area. Meaningful reforms include either significant moves to share risk across the region, such as introducing a Eurobond or a “safe European asset” that is backed by all euro area states; or agreeing to a banking union that consists of universal deposit insurance and a fiscal backstop for failed banks. In short, it assumes that Germany and other creditor states in Northern Europe do not agree to any form of risk sharing that ranges from debt guarantees to fully-fledged fiscal transfers.
Northern Europe and particularly Germany remain resistant. Last month, over 150 ordo-liberal German economists warned in a public letter against what they called a “debt union,” which would mean German taxpayers implicitly supporting other states. Chancellor Angela Merkel wants only limited reforms, including a European Monetary Fund that restructures debt and gives loaned assistance only if there are Eurozone-wide systemic risks and recipient countries implement structural reforms. This means exposing investors in troubled states’ bonds to haircuts and lengthened maturities during times of stress.
Unfortunately the German proposals, supported by the Netherlands and Austria, as they stand serve only to crystallise all of the problems that arose from the euro crisis of 2011-15. Merkel’s debt restructuring plan would weaken private sector confidence in peripheral sovereign bonds and reopen the possibility of self-fulfilling fiscal crises. It enacts punishing and self-defeating austerity regimes on troubled debtors, and strengthens the position of German Bunds as a safe asset. Italy will want a bolder approach, and they are likely to push for that ahead of the next EU summit on June 19th. France too will expect bigger concessions after implementing domestic reforms in labour markets and public spending as a quid-pro-quo for more economic integration.
The risk of a future Italian debt crisis also assumes that the ECB will not continue to backstop Italy’s sovereign bonds. This happens by default if the bank eventually moves into a phase of shrinking its balance sheet, but if the next governor of the bank, who takes office in October 2019, takes a more hawkish point of view, as is the preference of the German government, support for Southern European sovereign bonds in a future crisis scenario may not be there. Considering that it was Mario Draghi’s commitment in 2012 to do “whatever it takes” to contain the last crisis, a reversal of that commitment would create clear dangers.
We therefore face the possibility that the political ambitions of Italy’s new government could be thwarted by other countries and the European institutions. The question then becomes whether the populist government could credibly threaten to leave the euro and throw Europe into turmoil to extract concessions from the other countries. The answer is probably ‘no’ as euro-exit would decimate the Italian middle class. However, the systemic importance of Italy in the euro area and the recent shock of Brexit should focus policymakers.
Events in Europe in the last month show that there are still significant tensions between member states that cannot be solved by a short-term burst in economic growth across the region. Yet as that growth starts to slow and the ECB tightens policy, conditions will not be more favourable than they are today to agree the necessary reforms.
What is needed is a greater sense of pan-European solidarity in which your typical German Bavarian thinks of the concerns of the Italian Neapolitan with the same empathy with which she considers the problems of her immediate compatriots. That’s a multi-generational project. In the absence of that, Europe will continue to evolve through crisis, yet always carrying with it the tail risk of breakup. Political risk in the region has clearly not gone away.
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