- The new Italian government has a radical agenda involving lower taxes and higher spending, and a more combative attitude towards the EU
- The proposed programme is likely to make fiscal sustainability concerns worse without any compensating boost to growth
- We think that ultimately, the ECB will intervene to guarantee Italian solvency, but it is a question of how perilous the situation can become before intervention becomes necessary
- In the long run, the significant concern is that this makes the politics of Eurozone reform very difficult. If the banking union is not completed and some form of common fiscal policy not achieved, the Eurozone will remain severely exposed to any economic risk as it was in the aftermath of the global financial crisis
With their respective memberships overwhelmingly backing the proposed joint programme in plebiscites over the weekend, a coalition between the Five Star Movement and League seems all but inevitable. Fears of a populist takeover of a major European economy have finally been realised. The Eurozone’s fourth largest economy now has a leadership openly hostile to the concept of the euro. In this blog post, we analyse the short-run and long-run implications of this for financial markets and the survival of the euro.
The coalition programme
From an economic perspective, the key things which made it into the final programme are:
- A version of a “flat tax”, as per League’s manifesto, with a 15% and 20% rate.
- A guaranteed income of €780 per month for poor jobseekers (the so-called “citizen’s income” which is a highly watered-down form of Universal Basic Income)
- A pledge not to raise VAT (as would happen automatically in the Autumn budget without intervention)
- Rolling back pension reform made under Renzi to raise the retirement age to 67
- Their policy on the euro is apparently “still under discussion”
Naturally, there are a number of implications for the Italian economy from such a radical programme. A caveat to the following is that the new government will have a relatively small majority (six) in the Senate. In particular, the aspects which are not common to both parties’ manifestos may not clear the legislature if party discipline is weak. On the other hand, brokering deals over the tax rises and spending cuts potentially required to balance the national budget may be difficult.
Between the Citizen’s income, the flat tax and the pension reform, the cost is estimated at around EUR100bn per year, or 5% of GDP. Given sluggish Italian growth and a large outstanding debt stock, this could imperil Italy’s fiscal sustainability. This is illustrated in Figure 1, which projects the debt-GDP ratio under the assumptions of a balanced budget, and the new government’s proposed spending plans. Naturally, this does not take into account the growth effects of the spending commitments but these are unlikely to change the picture significantly. The growth effects of League’s tax reform are highly uncertain, but most reasonable estimates of revenue-maximising tax rates would put them higher than 15%. Furthermore, for the growth effect of these reforms to lead to a neutral effect on the debt-GDP ratio, a 24% expansion of GDP would be required. There are also few proposals in the programme which look likely to raise Italy’s chronically anaemic productivity growth. In theory, the biggest risk here is not necessarily one of insolvency, provided the ECB continues to act as lender of last resort, although political pressure may prevent this function from being fully exercised. However, it increases the likelihood of painful economic reforms down the road and Italy’s long-term dependence on the ECB to guarantee its funding. As standards of living and economic performance continue to diverge within the Eurozone, its political viability comes more and more under threat.
Short-term European political stability
The most significant short-term source of animosity between the new Italian government and the EU will be fiscal spending. Earlier demands to exclude ECB-held debt from their sustainable debt calculation have been dropped, but the direction of travel is still a cause for concern. If Italy chooses to de facto break the Eurozone’s fiscal rules, the Commission and ECB have no real source of leverage against them. In theory, an Excessive Deficit Procedure would be instigated, but in practice, this has very little teeth. Despite the threats in the Stability and Growth Pact, no fine has ever been imposed on an EU economy, most likely because the Commission knows they would have simply refused to pay. The most likely break on Italian spending plans is a threat from the EU to withdraw ECB lending without fiscal reform. This risks politicising the ECB, though. At the same time, the Italian government looks to have little leverage versus the EU. Any threat to leave the euro would be incredible given that most Italians continue to support membership (Figure 2).
Given the spending plans of the government, and the toxic political fallout, investors will likely be concerned. The key factor ensuring the long-run solvency of the Italian economy is the ECB. It is still purchasing around €4billion of Italian debt per month and would realistically increase these purchases were the solvency of the Italian government seriously in question. There is a major political risk associated with this approach, though. In the current environment, where Northern policymakers already feel that QE has outstayed its welcome, ECB intervention to ensure the solvency of a profligate peripheral economy would be toxic. In extremis, if Italian fiscal policy prevents the ECB from tightening as inflation increases in the rest of the Eurozone, it would be a particularly pernicious form of policy insolvency, with attendant grievance for the rest of the Eurozone. Thus although the ECB will likely intervene before capital flight threatens Italian membership of the euro, Italy may experience significant pain before this help is forthcoming.
The new government will be a thorn in the side of Eurozone reform efforts. While ostensibly M5S railed against banking, the demands being placed on Italian banks to set aside more capital for NPLs could be resisted by the new government if they come from the ECB or the European Commission. Assuming that Germany continues to insist on this as a prerequisite for completion of the banking union’s common deposit insurance scheme, this looks as though it could derail banking union completion altogether. As significantly, the political dynamics described above could sour European politics to the extent that any enthusiasm for reform of the Eurozone’s institutions will be lost. For European reformers, this has come at the worst possible time.
The tide appears to be turning against meaningful Eurozone reform in any case. In German finance minister Scholz’s recent budget speech he ditched any commitment to putting the European Stability Mechanism into EU law, providing a fiscal backstop to the Single Resolution Fund, and enlarging the EU budget. This confirms that the German government is backtracking on Macron’s proposed reform agenda.
The danger of these developments to the long-run viability of the Eurozone cannot be overstated. Regarding the banking union, the danger of not having a fully-funded Single Resolution Mechanism is that in a crisis, responsibility could fall again to national governments. With a banking sector balance sheet 2.3 times annual GDP and a recent history of bank bailouts (in the face of Single Supervisory Mechanism rules), this is a particular concern to Italy. With deep cross-border financial linkages, the politics of this can be very messy (as we have seen in the past). Likewise, without a common deposit insurance scheme, any banking crisis will infect the economy more viciously.
On macroeconomics, the Eurozone remains exposed to asymmetric shocks. Under the current set-up, an economy faced with a drop in domestic demand is unable to use any of the usual adjustment mechanisms. Nominal exchange rate devaluation is precluded by euro membership, monetary policy expansion is not possible without a change of ECB policy, and fiscal expansion is in theory prohibited by the Stability and Growth Pact, and de facto ruled out by the already high levels of government debt in most of the peripheral economies. The only adjustment available to the economy is a painful internal devaluation. With political relations between the South and North of Europe likely souring and the probability of significant European-level spending to balance demand across the Eurozone shrinking, the periphery of the Eurozone will be just as exposed to the next crisis as the last.
There are many ways this could result in a benign outcome. For one, Italian governments are notoriously short-lived, and with two inexperienced parties with such divergent outlooks, it is possible that this one will not survive long enough to do significant damage. The risks are significant, however. It would be a mistake to interpret these as entirely economic. So long as a central bank can bail out its government, fiscal insolvency (as opposed to policy insolvency) is not actually a major risk. There is a question of how much pain the ECB will subject Italy to before intervening, though. This introduces short-run risk for Italian fixed income, and most likely the euro. In the long run, however, the major risks are to the Eurozone itself. The nature of the Eurozone’s setup is that the political fallout from the steps the ECB would have to take to ensure financial stability could be very painful. This could stymie reform efforts. The Eurozone was woefully unprepared for the last economic crisis; the new Italian government might kill off its hopes of being in any better shape next time.