Thread warning. Some thoughts on where the Italian crisis might lead us.
The smart money in Italy seems to be on a further populist victory in coming elections. Their supporters are energised and angry, and the opposition to them lacks a clear narrative or effective leader. Talk of a republican front is interesting but a long shot.
So it looks like we’ll be back in the same situation in a few months time, but with a stronger populist mandate and a politically weaker president. At that point the prospect of a sovereign debt crisis will be back on the table.
With a populist gov’t in place and markets nervous, attention will turn to eurozone policy makers and how they intend to react to the new gov’t. The actions of the ECB will also be critical.
First thing to note is that the reason markets are nervous is that the single currency is still vulnerable. Nothing done since last crisis has put the euro’s solidity beyond doubt. Bail-out funds aren’t big enough for a case like Italy. Macron’s fiscal union isn’t going anywhere.
The banking union is incomplete and not being implemented consistently. The common n thread in these remaining weaknesses is the lack of political willingness to sign up to genuinely common European solutions.
In the heat of an Italian sovereign debt crisis, we can expect leaders to reach for more. Bigger bail-out funds. A common European budget, and maybe some issuing of euro bonds. But to get this past voters in Northern Europe the conditionality would have to be severe.
And there is no appetite at all for more austerity in the south. Even if leaders emerge with a plan at 05.00 in Brussels one morning, there is no reason to suppose they could make it stick politically. Eurosceptic rebellion in north and south would be fuelled by this scenario.
So one key question is will eurozone leaders avoid this trap by finding ways to work with the Italian gov’t to avoid a sovereign debt and euro crisis in the first place? A good place to start would be to acknowledge the years of fiscal discipline Italy has already shown.
Italy has been running primary budget surpluses for years. It is labouring under a much older debt burden and paying interest on that. A decent case can be made that its economic problems are caused by under spending, especially on infrastructure.
Instead of criticising the new gov’t it should also acknowledge that some Italian sovereign debt restructuring would be a good thing. It could still pressure Italy to carry out reforms but could choose to be much more flexible in its approach.
A wise move, instead of pursuing fiscal union with tight rules, would be to opt for fiscal decentralisation with a new treaty commitment by each member to pursue counter cyclical fiscal policies. Spending more in down-turns and trimming when things are good.
This approach overall would not only help avoid a sovereign debt crisis but would be beginnings of providing single currency with a political strategy. A strategy that demonstrates euro membership is not an unresponsive straight-jacket but can accommodate diff. national choices.
Between now and next election the eurozone has time to think this through instead of doubling down on a rigid approach that is politically unsustainable.
It will not be saved from needing to confront this by indefinite bond purchases by the ECB. In a full confrontation between Italian gov’t and the eurozone, it will not unconditionally continue such purchases indefinitely. Politically, that won’t be sustainable either.
And even if it did it would be giving a green light to everyone else to stop taking note of eurozone rules. Nor will the ECB get away with its previous tactic of forcing an Italian climb down by threatening to cut off liquidity to Italy’s banks. Italy is not Greece.
Italy is so big its apparent weakness will give it power in the negotiations. Its exit from the euro could hurt not only itself but lots of others. There is German wealth around Europe waiting to be defaulted on. So even in heat of crisis, flexibility will need to be found.
Much of this is predictable. Far better the eurozone adapt its strategy in advance to give Italy some of what its citizens want, and avoid the crisis altogether.
