DER SPIEGEL STAFF. Italy’s New Goverment Is Bad News for the Euro.May 28, 2018
Two populist parties are set to take over the government reins in Italy and about the only thing they seem to agree on is their desire to spend huge amounts of money. That’s bad news for Italian finances and terrible news for the eurozone.
Signor Fabio doesn’t think it will take long. The new Italian government, he believes, is destined for a brief tenure: “In September, we will be voting again,” says the slender man in the center of Rome. Signor Fabio is the giornalaio — or newsstand proprietor — with the most attractive kiosk location in the capital, situated as it is fewer than 100 meters from the prime minister’s office. He knows what’s going on in the world and that people are once again looking to his homeland with concern.
“Rome Opens Its Gates to the Modern Barbarians,” was the headline chosen by the Financial Times 10 days ago in an editorial about the new government, which pairs the Five Star Movement (M5S) under the leadership of Luigi Di Maio with the right-wing nationalist party Lega, led by Matteo Salvini. But Italian papers weren’t any less critical. The daily Il Manifesto went with the headline “Populandia,” in reference to the populist natures of the two parties. “The Third Republic Is Formed as the Whole World Laughs,” wrote Il Foglio. And Libero wrote: “Mattarella Chooses the Rotten Apple: Mini-Premier Conte.”
The latter is a reference to Salvini’s and Di Maio’s inability to agree on which of the two should become prime minister, so they chose the completely inexperienced law professor Giuseppe Conte. While he is closely connected to the Five Star Movement, Conte has never held public office — and now he is being asked to lead Europe’s third largest economy, with a population of 60 million people.
This government, the 67th in the last 70 years, is perhaps the most unusual and least experienced of them all. At the top are two populists who are critical of the EU and friendly to Russia, two coalition partners who share few joint political goals and whose supporters hate each other. The one party, Lega, draws the majority of its support from the wealthy north while the other, M5S, has its roots in the comparatively poor south.
“It’s like if Germany were governed by Sahra Wagenknecht (from the Left Party) and Alexander Gauland (from the right-wing populist Alternative for Germany),” says Markus Ferber, vice-chair of the Committee on Economic and Monetary Affairs in European Parliament and a member of German Chancellor Angela Merkel’s Christian Democrats.
Making the Problems Worse
The difference being, of course, that Italy holds 2.3 trillion euros in sovereign debt, the equivalent of 132 percent of its gross domestic product — a debt ratio that is only exceeded within the EU by Greece. In addition, the country is still suffering from the consequences of the financial crisis, including high unemployment, particularly among young people, and it is struggling to deal with the strain of the thousands of migrants who are still streaming across the Mediterranean to Italy.
The country has been among the EU’s problem children for years. As such, the election victory by the populists is hardly surprising, rather it is the logical consequence of the problems facing the country. But at the same time, it has the potential to make those problems much worse.
To satisfy the desires of their vastly different constituencies, Salvini and Di Maio included tax cuts, a minimum basic income and the retraction of the recently passed pension reform in their coalition agreement. According to the calculations of Carlo Cottarelli, a former director of the Fiscal Affairs Department, these measures will cost at least 109 billion euros per year.
Jörg Krämer, chief economist at Germany’s Commerzbank, warns that if the new government pushes through its proposals, the country’s budget deficit, which currently stands at 2.3 percent of GDP, would spike to fully 7 percent.
The two parties refer to their coalition agreement as the “Contract for the Government of Change,” but in actuality, it is a blueprint for destroying state finances. And the consequences for Europe will be impossible to ignore. “The eurozone is threatened by a new crisis,” says Clemens Fuest of the Center for Economic Studies in Munich.
Concern is particularly high in Brussels, but officials there are avoiding direct criticism for the time being, likely in the hope that things won’t ultimately turn out as bad as expected. At an economics conference on Thursday, European Commission Vice President Valdis Dombrovski was asked if the new government’s program would comply with the Stability and Growth Pact, one of several questions about Italy. The Latvian looked visibly uncomfortable before finally replying: No, probably not. He added that he is particularly worried about rising risk premiums on the bond markets, a trend that has also affected other weaker eurozone member states. The prospect of countries not acting responsibly when it comes to fiscal policy has consequences, he said. It is important that all member states adhere to the rules that have been agreed to if they are part of the common currency area, he added.
French Economics and Finance Minister Bruno Le Maire is more direct. “If the new government takes the risk of not respecting its commitments on debt and the deficit … the financial stability of the eurozone will be threatened,” he told French broadcaster CNEWS last Sunday.
Indeed, even if the EU and the euro might have been able to withstand Grexit, an Italian departure from the common currency zone would likely be its death knell. Italy’s economic output is almost 10 times higher than that of Greece. “Given its systemic importance, the Italian economy is a source of potential spillovers to the rest of the euro area,” the EU warns in its most recent set of country-specific recommendations released on Wednesday of this week.
The recommendations, which are issued at regular intervals, recognize the efforts thus far undertaken by Italy to reduce its debt levels, but those efforts were all the product of the previous government. The new powers-that-be in Rome have left no doubt that they intend to focus their attentions elsewhere.
EU laws, says Lega head Salvini, will only be respected in the future if they are beneficial to Italy. And Di Maio of the Five Star Movement adds: “Starting now, the Italians come first and only then the negotiations about the deficit and EU rules.”
That approach is consistent with the intention to appoint 81-year-old economics professor Paolo Savona as economics and finance minister, a man who is considered a fierce critic of the euro. Savona’s new book, “Like a Nightmare, Like a Dream,” will soon be hitting the shelves. In it, he writes: “The euro is a straightjacket produced in Germany.” Berlin, he continues, “hasn’t changed its view of its role in Europe since the Nazi era.” Membership in the common currency area, Savona writes, “involves fascism without dictatorship and, from an economic perspective, a form of Nazism without militarism.”
One wonders whether the aging academic from Sardinia will repeat his verbose criticisms when he sits down with his German counterpart Olaf Scholz at the next European Union summit.
Di Maio’s people, of course, are doing their best to assuage fears of megalomaniacal populists driving Italy, a founding member of the EU, over a cliff. “We are in constant contact with the U.S and German embassies and we value complete transparency,” says one of Di Maio’s closest confidantes.
But such words are cold comfort. The advance of the populists, after all, is coming at a difficult time for the EU. The block is still enjoying solid economic growth, but a potential trade war with the United States is looming and the consequences of Brexit must likewise be overcome. A rekindling of the European trench political warfare that accompanied efforts to save Greece would be devastating.
Exactly that, though, appears to be on the horizon.
In the French elections one year ago, the feared victory of extremist, anti-Europeans did not come to pass. But right-wing populists are nevertheless on the march. They are the most powerful opposition party in Germany, they are part of the government in Austria and now they have joined the Italian government. “Our allies,” said Marine Le Pen, the head of the French right-wing party Front National, “are laying the groundwork for the great comeback of nation-states.”
Italy will “become the leader of Europe’s populist, anti-establishment movement,” says Steve Bannon, Donald Trump’s former chief strategist, who is expected in Rome on Sunday. It marks the first time that Brussels will have to contend with an anti-system government in one of the EU’s founding countries. Bannon is excited about the triumph of Di Maio and Salvini, who are demanding that sanctions against Russia be wound down. “It’s very important for these guys to be very aggressive about confronting Brussels,” Bannon told the Washington Post this week.
Such an approach would almost certainly be popular in the country, where only 39 percent of Italians view the EU positively — not a good sign in what was once the most pro-EU country in the block. Part of the country’s frustrations with Brussels stems from the feeling of having been left alone to deal with the Mediterranean migrant crisis. In addition, many voters who have suffered from years of recession see the warnings from Brussels as heavy-handedness.
The fact that Italians, who traditionally have a high rate of savings, stand to suffer significant losses should the country withdraw from the eurozone is something neither M5S or Lega have addressed. The parties have also remained silent about the European Central Bank strategy — pursued by its Italian president, Mario Draghi — of buying hundreds of millions of euros worth of Italian sovereign bonds to prop up the country’s economy. On the contrary: an early draft of the coalition agreement demands that the ECB forgive 250 billion euros of debt.
“Fantapolitica,” is the term that reasonable Italians have adopted to refer to such demands: “fantasy politics.”
As it currently stands, Italy requires 200 billion euros of fresh borrowing each year to service old debts, says Klaus Regling, head of the European Stability Mechanism (ESM), the eurozone’s bailout fund. The fund has immediate access to 400 billion euros, meaning it could finance Italy for two years if need be. But only if no other eurozone country falls victim to the turbulence such a crisis would no doubt trigger.
But exactly that scenario is what has many people concerned, with pressure on Spain and Portugal likely to increase. The two countries have, to be sure, made progress in cleaning up their state finances, but they are still vulnerable, and their debt loads remain high.
Even if the Italians don’t proactively cease servicing their debts, they could still face trouble. Credit rating agencies already hold a dim view of Italy. Were they to downgrade Italy two additional levels, Italian bonds would reach junk status, meaning that many investment funds would be forced by their own regulations to dump them.
If mistrust and interest rates rise, Italian banks could once again find themselves in a dire situation. In the last 12 months, they have managed to reduce their risk exposure, but they are still sitting on billions of euros in bad loans. If the new government chooses to ignore these risks, the situation could rapidly spiral out of control.
Already, the interest rate difference between Italian and German sovereign bonds — the so-called risk premium — has risen significantly. In recent weeks, it has climbed by almost an entire percentage point. The difference reflects the higher risk of default for Italian bonds. Investors are only prepared to loan more money to Italy if they receive higher interest rates for their troubles.
Bailing Out Italy
Back in February, hedge funds already began speculating on falling European stock prices on the assumption that an anti-EU government in Rome could fragment the currency union. Bridgewater Associates, one of the largest sharks in the tank, placed a $22 billion bet against European stocks. The most recent wave of Italian sovereign bond sales was also likely driven by hedge fund speculation.
There is significant concern in many European capitals that the Conte government might operate under the assumption that Italy is too large and important for Europe to allow it to slide into bankruptcy and that European institutions would ultimately jump in to bail the country out. After all, roughly a third of Italy’s sovereign debt is held by foreign investors — a total of almost 800 billion euros. If a 50 percent debt haircut came to pass, as was done in the case of Greece, banks, insurance companies and pension funds would be forced to forego claims to 400 billion euros.
“The economic situation in the country has been highly explosive at least since the 2008 financial crisis,” says Henrik Enderlein, an economist at the Hertie School of Governance and an advisor to the German government. “But now a government is coming to power that is like a burning match and which could result in the situation getting out of control.”
The only thing left is to hope that this government of post-ideologists and right-wing populists will ultimately see the light — just as Alexis Tsipras did not long ago in Greece. “Leaving the common currency would be the worst-case scenario for Italy,” Enderlein warns. The country would sink into economic insignificance, he says, not unlike Argentina after its 2001 collapse.
European hopes are primarily focused on one person: Italian President Sergio Mattarella. “He will make sure that the new government adheres to European rules,” says a Brussels diplomat.
For most of the last three months, the 76-year-old lawyer has been patiently seeking to enable the assembly of a stable government and avoid new elections. And there is nothing he has left untried. He even held a face-to-face with Silvio Berlusconi, the man who paved the way for the rise of the populists and who led Italy into the crisis. Finally, though, the current coalition took shape, even if it looked for a time as though it was hopeless.
But even if Mattarella can prevent the worst — by refusing to sign certain laws, for example — he cannot prevent the political uncertainty from blocking a central EU reform project, that of reforming the economic and currency union.
Currently, Europe is waiting for the German response to French President Emmanuel Macron’s proposals, which he delivered eight months ago in a speech at the Sorbonne. Macron would like to see a joint eurozone budget and a common deposit insurance regime, among several other ideas.
Spending Even More
“The current developments in Rome are the death blow to Macron’s reform agenda,” says Commerzbank chief economist Krämer. Every step toward the collectivization of risk or debt, he says, “would be an open invitation for Italy to spend even more.”
Even if Macron is now carefully choosing his words and repeatedly saying he respects “the decision of the Italian people,” developments in Italy are, in fact, a significant setback for him and his reform proposals. He is caught between a Berlin that cannot seem to make up its mind and a Rome that is deeply skeptical of the EU. Realizing a vision of a unified, strong Europe won’t be easy with partners like that.
Concern is growing in the Élysée Palace in Paris that Europe is facing its next significant crisis and Macron, instead of pushing through his reform plans, will be forced to spend his time on damage control, not unlike his predecessors. “Salvini and Di Maio won’t achieve anything for Italy, but they will be in a position to completely block Europe,” says one of Macron’s advisers. The term “crazy,” the adviser says, would be a polite way of describing the new Italian government’s program.
The concerns are justified, particularly given the enormous resistance against Macron’s reform plans that already exists in German parliament. One element of those plans that is controversial is the “common backstop” envisioned as part of the banking union. The banking union envisions shareholders and creditors initially being made liable in the event of a bank collapse. Now, though, the use of the backstop — public money — is under discussion for extreme cases in which the costs of winding up a failed bank cannot otherwise be covered.
German politicians and others who oppose Macron’s vision fear that savings account holders could ultimately be made to pay for financial institution bankruptcies in countries like Italy. This fear has not been reduced by the anti-European rhetoric currently coming out of Rome. Indeed, the situation in Italy is not a good omen for the EU summit at the end of June, where heads of state and government intend to discuss a deepening of the eurozone.
Yet despite all of the justified concerns, it is also true that the coalition in Rome hasn’t actually entered office yet. The alliance with the aggressively anti-immigration party Lega is a controversial one within the Five Star Movement. “We have lost a few supporters along the way,” admits a spokesman for Di Maio. Furthermore, their parliamentary majority is just 30 seats. That isn’t much in a lawmaking body in which 206 representatives changed parties in just the last legislative session.
And should the new government suffer a premature demise — a fate which, Silvio Berlusconi insisted last week at the European People’s Party summit in Sofia, is one he would certainly hate to see — then the former Italian prime minister, now 81 years old, has a couple of thoughts on what should happen next.
In a good mood due to the recent decision by an Italian court to lift the ban on him holding public office, Berlusconi said he would be happy to do all it took to prevent a state crisis in Italy. And he would, of course, be prepared to “take on responsibility.”
This article was first posted by Spiegel Online on the 25th of May, 2018.
It was written by Martin Hesse, Julia Amalia Heyer, Walter Mayr, Peter Müller and Christian Reiermann.