Italian assets suffered steep declines ahead of the formation of a new government backed by the left-wing M5S and the nationalist Lega. We expect a lengthy stand-off between the new government and the EU as well as the markets. However, policies and their implementation are too vaguely formulated to be able to conclude that a major crisis is imminent. In fact, the political establishment in Europe may have more to fear than the markets.
Both parties agreed to a tentative economic policy package that combines generous tax cuts for Lega’s wealthy backers in the North with higher social security payments to M5S supporters in the south. Little details are known about the cost of these policies, though estimates suggest they could easily reach 5% of GDP, a clear violation of the Stability and Growth Pact, if financed by deficits.
In addition, the coalition partners are considering several economic policies that would result in material conflict with the EU and the ECB should they be implemented. Apart from higher government deficits, these include a lower pension age, the reversal of the banking sector reform, nationalisation of Monte dei Paschi and the introduction of a parallel currency (mini-BoTs) to finance the deficit.
How realistic is the outcome?
Such a German-style coalition “treaty” is unusual for Italy and the question is whether this is a serious attempt at formulating policy or simply a tactical move to shore up public support and put pressure on a sceptical president to let M5S and Lega govern the country. Few, if any, of these policies will pass the scrutiny of the president, the constitution and the two chambers of the legislature, where the coalition only has a slim majority of six seats in the Senate.
While coalition partners are considered “anti-establishment”, the two parties come from opposite ends of the political spectrum, which bears the question how stable the coalition will be. The fact that the two parties are to elect a technocrat prime minister with no political base of his own is equally not a sign of confidence, especially by M5S as the largest party and clear winner of the general election.
Indeed, one could argue, the only binding element of the coalition seems to be Europe as the common enemy. Nevertheless, the coalition partners’ plan and anti-EU stance enjoy significant public backing, which especially benefits the nationalist Lega party. While this may not last, the clear message of the polls to the president and the other parties is that new elections are simply not an option.
What will the EU response be?
The EU will struggle to deal with the new political environment in its 3rd largest member state, that has the 4th highest stock of traded government debt in the world. After years of sclerosis and ignorance, Lega and M5S symbolize lasting generational change in Italian politics with an uncertain but most likely nationalist direction reminiscent of the pre-euro days.
The coalition will seek confrontation with Berlin, Brussels and Frankfurt, not at least to divert attention from problems at home. It remains to be seen what allies, if any, Italy can find among other euro area members, such as Greece or Portugal, and in the wider EU, where Poland and Hungary follow an equally confrontational course. The French economy minister already warned that France considers any disrespect for EU budget rules as a threat to the euro.
While the initial European response may well be a rhetorical hardening of positions, especially on fiscal matters, the weak architecture of the euro area does not allow for a robust crisis response should the Italian government press ahead with its plans. Thus, while Germany and its allies may push for fiscal discipline, France and the Commission may seek to avoid a direct confrontation.
Markets hostage to sentiment
Italy has been able to stabilize its debt position in recent years thanks to primary surpluses and ECB support. Domestic leverage is low, and few government bonds are owned by non-residents, which makes a liquidity crisis unlikely.
However, the new government has very limited room to expand fiscal policy, given its high debt level relative to GDP. Broad-based tax cuts by lowering the top bracket from 43% to 25% could cost up to 3% of GDP. If combined with an increase in social security spending estimated at EUR 17bn and a lower pension age, the policy package could cause multiple ratings downgrades, thus shutting the government out of the investment-grade bond markets and endangering domestic banks’ access to the ECB. The coalition partners are aware of this in light of recent market reaction but may still choose to enter into a lengthy stand-off to extract concessions from the EU or the ECB to improve their standing with eurosceptic voters at home.
Addendum: Mini-BoTs – the icing on the Eurosceptics’ cake
The creation of a parallel currency by large-scale issuance of cash-like, small-denomination T-bills would undermine the euro as the sole legal tender in Italy and lead to a direct confrontation with the ECB and other euro area countries. Euro-denominated IOUs issued by the Italian Treasury will be inferior to euros issued by the Banca d’Italia, given that the former has no legal tender and are of no value outside of Italy. That means the government would have to pay more in mini-BoTs than in euros to procure goods or services. At the same time, the IOUs would become the preferred means of settling tax bills since it would be a cheaper option than euros. Thus, the strategy would come at a cost to the government and deliver windfalls for those with tax arrears and access to government contracts paid in IOUs. Proponents will point to the expansive effect of the deficit on GDP, which could become relevant should the ECB tighten policy in the coming years. However, in large amounts, the “bad” IOUs would eventually drive out the “good” euros that people would instead hoard to use abroad – as Gresham’s law stated back in Tudor times.
Before Fidelity, he worked for Deutsche Bank in London and as Deputy Head of Credit Risk for the BIS in Basel, where he advised central banks and regulators on bank capital and risk management.
Joachim Bitterlich is a BGA Advisor and was Ambassador of the Federal Republic of Germany to NATO and Spain. Before holding these roles, he was the Foreign and Security Policy Advisor to Chancellor Helmut Kohl, working primarily on European Integration Policy.
Entering the Federal Foreign Service in 1976, he also held posts in Algeria and Brussels. From 1993 to 1998 he was Head of the Chancellery’s department for Foreign, Security, and Development Policy. More recently, he was Executive Vice President International Affairs of Veolia Environment in Paris, where he was responsible for the German market.
Andreas has a combined 30 years of work experience. He served for two years as an officer cadet in the German Army, and worked more than 14 years in the academic field as research and teaching assistant in the area of applied political science. Moreover, Andreas has a record of active engagement in German party politics, including several years in party and (local level) public offices.