Finance: Research, Policy and Anecdotes

A lot has already been written about the new Italian government and the possibility of a new Eurozone crisis, so it is hard to be very original.  However, in the following I will try to bring several different dimensions to this problem together.

As I wrote about a year ago in the context of an early evaluation of the banking union,  “the future of the Eurozone might very well go through Italy.” Well, here we are at another cross-roads, with financial markets finally waking up to the reality of Italian sovereign debt unsustainability, continuous banking fragility, and a high degree of political uncertainty if not outright instability.  Another prediction that I have made is that the next big shock will be a political one (even though the shock is the result of long-running economic trends, in the case of Italy the lack of growth over the past decade or so).  

2016 was the big shock to liberal democracy on both sides of the Atlantic and to European integration, with the Brexit referendum and the election of Donald Trump. 2017 seemed to offer a relieve, with the election of Mr. Macron in France and confirmation of mainstream governments in Netherlands and Germany.  2018 has seen a swing back towards populism, with populists entering government in Austria and an illiberal government confirmed in Hungary. The populist wave has clearly not receded. And while Italy is thus only one more “populist revolt” against liberal democracy and the European project, it could turn out to be the fatal one, given the twin problems of sovereign and bank fragility and their close links.

It was interesting to see the very different reactions to the rejection by president Matarella of the suggested finance minister Paolo Savona, which then led to M5S and Lega withdrawing from government formation and aiming for new elections (side note: I met Paolo Savona a few years ago at a conference dinner and was struck by the rather strong anti-German sentiments he expressed.  Given that it was a social setting I decided not to engage him on his views).  Many Italian observers point to the constitutional right of the president to veto individual minister appointments and the sound reasoning by the president that an accidental or intentional Euro-exit had not been part of the election campaign.  On the other hand, the veto of the president against Mr. Savona was interpreted by many non-Italian observers as strategic blunder, strengthening the hand of the populists.  Well, the president might have played his cards well after all, as M5S and Lega gave in and suggested someone with less outspoken views, though Mr. Savona will still be part of the government, as minister of EU Affairs – one wonders what his role exactly will be.

While the markets have shown nervousness, we are not quite in a crisis yet (and might never get there), but such a crisis might get triggered by an aggressive expansionary fiscal policy by the new government. How can such a crisis work out?  Based on experiences from previous Eurozone crises, there are several scenarios.  One would be that the Italian government can no longer tap funding at a reasonable cost and would issue IOUs as form of payment, effectively a parallel currency. Another “entry point” into the crisis could be a depositor run or walk as reaction to continuous rumours on an imminent exit of Italy from the Eurozone.  And with Italian government bonds (still held by Italian banks) experiencing more and more haircuts, there might at the end only be the option of capital controls as banks run out of collaterizable assets to gain access to liquidity (as in the case of Greece and Cyprus). Yet another option might be another bank failure, which could result in depositor panics across Italy, with brings us back to the scenario above.

Many observers point to the ECB as ultimate backstop, but to which extent can the ECB step in?  Yes, the ECB has many tools available to serve as backstop for banks and, ultimately, even governments and has been creative in creating additional tools over the past 7 years.  However, there are important constraints.  One, the OMT (introduced after Draghi’s whatever it takes but never used) is contingent on a government working with the ESM – but would a populist government be willing to do so?  Two, there has been a backlash against the ECB in Germany (and to a certain extent in other core/creditor countries) against “bail-outs” of periphery/debtor countries and an accommodation of populist government in Italy might lead to a rise in right-wing populism in Germany and other countries, which again might restrict the appetite of the ECB to underwrite the Italian government and banks for long.

Which brings me to the next point – a lot has been written and argued about the populist revolt in the periphery countries, but the past days have seen a similar populist backlash in Germany, quite ferocious if not rather tasteless.  While primarily playing out in the media, some German economists are fuelling this and providing intellectual fodder for this. It is very obviously the wrong reaction to increase tensions further, even though it won’t only be the Germans who will complain that they might have to indirectly pay for pension increases in Italy and minimum income, while some of the creditor countries (e.g., in Central Europe) have lower levels of income and wealth than Italy.  This will narrow the space for compromise within the Eurozone even further!

This new flare-up of the Eurozone crisis has made clear that the chance to complete the Eurozone architecture over the past years has not been used properly. The lack of a sovereign restructuring mechanism, the incomplete banking union and the failure to more aggressively address the links between government and bank fragility are coming back to haunt the Eurozone.   And it is in Italy that the failure to address such problems are most obvious. In addition is the failure to address legacy problems, both in the banking system but also in terms of sovereign overindebtedness.

Not talking about the high Italian debt burden (as suggested by some well-meaning Italian officials) no longer helps!  As pointed out by Barry Eichengreen and Ugo Panizza in this Economic Policy paper in 2016, it is politically improbable to expect a democratically elected government to run the large primary surpluses needed to reduce the high debt burden.  Here, we are a few years later, with exactly the result that the new populist government has no intention whatsoever to maintain the necessary fiscal discipline and rather focuses on higher expenditures (courtesy of the basic income proposed by M5S) and lower taxes (courtesy of flat tax proposed by Lega)

Where do we go from here? First, looking yet again to the ECB as lender-of-last-resort would be dead-wrong! The ECB has been already overburdened in the last 8 years. This is not just an economic, but a political crisis – a legitimacy crisis of the Italian state and legitimacy and governance crisis of the Eurozone.  Political solutions are called for!   And as pointed out by others, the Eurozone reforms proposed by Macron do not really address the Italian problem. This is not about risk-sharing, rather than about low productivity growth and structural problem, including a high NPL burden.

Ultimately, what Italy needs are reforms originating in Italy, but with support from its European partners (sorry if I use this rather political term, but maybe it helps moving away from the war-like language that has started to creep into the Eurozone debate). Structural reforms have acquired somewhat a bad taste, but are still necessary. And they can work, as shown in this recent Economic Policy paper.   And as we have learned from the German experience, accompanying such reforms with fiscal loosening can be helpful and it is here that flexibility from the European Commission is called for.  Which leaves us with the sovereign overindebtedness and NPL overhang.  For both, solutions have been proposed, for the sovereign overindebtedness as well as the NPL problem.  None of these are politically easy to achieve as it involves painful political compromises on the European level and might not be easy to sell in any of the debtor or creditor countries. But it might turn out the only viable option.  And it will require political leadership!

Finally, all this doomsday talk might be seen as yet another “crying wolf” by overconcerned economists.  But even if Italy and the Eurozone might somehow muddle through this “situation”, the structural problems of the Eurozone architecture continue – and will come to light during the next political shock!

Overview