Italy's President Just Undermined the Euro
(Bloomberg Opinion) -- Italian President Sergio Mattarella might think he has taken a principled stand in vetoing euroskeptic Paolo Savona as finance minister, effectively disallowing a government led by the Five Star Movement and the League. But in rejecting the choice of a popularly elected coalition, he may well have set in motion a financial crisis from which it will be hard to pull back, and which could imperil the entire European project.
Mattarella’s disregard of recent political history displays an astonishing wooden-headedness. In October 2011, German chancellor Angela Merkel made a phone call to then Italian president Giorgio Napolitano, soon after which Napolitano grabbed an opportunity to replace Silvio Berlusconi with the unelected, Brussels-friendly technocrat Mario Monti. Although Merkel and Napolitano denied they had plotted to ease Berlusconi out, that's the impression that prevailed. The Economist unabashedly applauded Merkel for helping “get rid of clowns like Italy’s Silvio Berlusconi.” Many Italians fumed, believing that Germany had violated their national sovereignty.
It's thus not surprising that the euro-skeptic Five Star Movement gained popular support. In the February 2013 election, Five Star emerged with more than a quarter of the vote, politically humiliating Monti and making it the largest single party in the parliament. While the center-left Democratic Party held onto power (under three different prime ministers), anti-European sentiment in Italy grew. In the March 2018 election, Five Star and the League, another euro-skeptic party, won the voters’ favor and together achieved an absolute majority.
The simple truth is that traditional mainstream parties -- the center-right parties led by Berlusconi and the center-left Democratic Party -- have failed to deliver for too long. The average Italian is poorer today than when Italy joined the euro area in 1999. The pain has been borne disproportionately by young Italians, large numbers of whom are either unemployed or are so discouraged that they have chosen to not even register as unemployed. Mattarella and like-minded European observers view the Five Star and the League’s euroskepticism with horror. But Italians have made it clear that they want change.
No doubt, Savona was an abrasive choice: His proposed "Plan B" in case of euro exit was unworkable and alarmist, and therefore could have done Italy great damage. But amid its over-the-top rhetoric, the Five Star-League coalition makes some sensible proposals: The European Central Bank should give greater consideration to unemployment in making monetary policy decisions (as the U.S. Federal Reserve does) ; fiscal rules should allow greater latitude towards investment expenditure. Instead of giving the euroskeptics an opportunity to deal with the complexities of governing -- and to recognize the futility of some of their proposals -- Mattarella is attempting yet another technocratic government.
History’s warning is clear. Five Star and League will retain electoral clout and may even return strengthened. In the meantime, the gathering political and financial crises could have far-reaching consequences. Mattarella’s folly could not have come at a worse moment. The global economic sweet spot in the second half of 2017 is receding, and the Italian economy is still struggling to rev up. In the last few months, global trade growth has slowed, and Europe’s economic momentum has faded.
The economic arithmetic for Italy is sobering. Even with the ECB, in effect, buying nearly every new bond issued by the government, the yield on those bonds hovered around 1.8 percent in April. Now, they're nearing 3 percent. With annual inflation running at only 0.6 percent, that amounts to a real (inflation-adjusted) interest rate of more than 2 percent. Italy cannot afford such a high rate: Its pace of productivity growth is near zero, and its long-term economic growth potential is well below 1 percent.
The Mattarella-induced crisis could feed on itself: Real interest rates could rise further, even as the nominal interest rates charged to businesses and consumers increase and a slowing economy dampens inflation. Such high rates would choke the economy. The government’s debt burden, stubbornly stuck at more than 130 percent of gross domestic product, would become harder to repay as tax receipts decline. Italian banks, already laboring under the burden of non-performing loans, would face a new round of delinquencies.
The ECB is between a rock and a hard place. If it steps up and extends its bond-buying program, it will soon reach the self-imposed limit of one-third of all Italian government bonds. German and other “northern” euro area countries will rightly worry about who would bear the costs if the Italian government were to eventually default on that large stock of ECB-held bonds. If, under northern pressure, the ECB winds down its bond-buying, Italian real interest rates will rise even more rapidly, heightening the probability of an Italian recession.
Mattarella and his advisers are trapped in a European groupthink, which denies Italian citizens a voice in running their own country and rules out sensible compromises. In trying to preserve European orthodoxy, they may unleash destructive forces that they can't control.
©2018 Bloomberg L.P.