The Corner

Italy’s Vote

Sunday’s decisive rejection by Italy’s voters of the constitutional reforms proposed by the country’s center-left prime minister, Mario Renzi, was expected (thus the muted reaction in the markets), but it has revived fears/hopes that Italy might be on its way out of the euro.

The Daily Telegraph:

The Centre for Economics and Business Research (CEBR), a leading economics consultancy, said that following the vote it now estimated the chances of Italy staying in the Euro for the next five years had fallen below 30 per cent. The CEBR said that bitter three-month [referendum] campaign had demonstrated that Italian voters would not tolerate indefinitely the chronic unemployment, stagnant wages and Brussels-imposed austerity that now came with euro membership.

“There is no doubt that Italy could stay in the euro if it were pre­pared to pay the price of virtually zero growth and depressed consumer spending for another 5 years or so,” the group said in a note.

Judging by comments from the likes of Angela Merkel, there’s no sign that the EU’s leadership is prepared to change direction. The Daily Telegraph also noted this from Manfred Weber, the leader of the main ‘conservative’ group in the European Parliament:

“It is also a setback for those who want readiness for reform, those who want European countries to change. That is the only way we can deal with globalization”.

Weber is right. Much of Europe does need to change direction, but driving it into the ditch is probably not the best direction to choose.  And the ditch is where the euro—another of central planning’s long list of catastrophes—has taken Italy.

Italians have noticed.  Writing in the Financial Times, Gideon Rachman notes that “some economists believe the euro has been disastrous for Italy’s competitiveness, taking away the tools of currency devaluation and creating a deflationary environment that increases the debt burden.”

“Some economists” are right, and many Italians have made the connection.

George Magnus, writing in Prospect:

At its heart, Italy’s crisis is really about economic stagnation and has been so pretty much since the birth of the euro in 1999. In constant prices, income per head is now about the same as it was in 1995, and over 10 per cent lower than it was in 2006.

Now it’s true that it was not only ‘populists’ (to use that fashionable  term) who opposed the proposed constitutional reform, and it’s true that Italy’s woes cannot solely be attributed to the euro (far from it). It’s true too that the referendum was not, directly at least, about the EU or its vampire currency. Nevertheless, the result was, in many respects, a victory for opposition parties that do not look fondly upon Brussels.

Back to Rachman:

The Five Star Movement, led by comedian Beppe Grillo, played a prominent role in defeating Mr Renzi. Five Star is adamant in its demand that Italy regain sovereignty from Brussels and has proposed a referendum on leaving the euro. Mr Grillo also sees his movement as part of a general anti-establishment wave across the west and hailed the victory of Donald Trump in the US as a triumph over “the Freemasons, huge banking groups and the Chinese”.

The reasons that Italian populism may ultimately threaten the EU even more profoundly than Brexit are not simply to do with [the abandonment of] Italy’s traditional commitment to the European ideal. Also crucial is the fact that Italy uses the euro while Britain has kept its own currency. So, while Brexit is a painful and complicated business, it does not directly threaten the survival of the single currency — or risk unleashing a financial crisis. However, the chain of events set off by Mr Renzi’s referendum defeat could potentially do both.

The immediate danger is to the Italian banking system. In the new atmosphere of crisis, the proposed recapitalisation of troubled lenders — in particular Monte dei Paschi di Siena — is threatened. That could lead to demands for state bailouts, which will be difficult given that the state is already heavily indebted. Revived worries about the size of Italy’s debt could then frighten investors, driving up interest rates and threatening the solvency of the Italian state itself.

And the problem isn’t confined to Monte dei Paschi di Siena.

George Magnus:

[O]ther banks are also as close to insolvency as makes any difference and also need to raise capital. Even Unicredit, the largest lender, needs to raise about €13bn. Earlier this year, the government estimated that troubled financial institutions would need to raise about €40bn.

The backdrop here, of course, is the deadweight of bad or non-performing loans, which has arisen not so much because of reckless lending, but because of years and years of no growth in the economy, and the evolution of zombie loans to zombie companies. When other Eurozone countries had to address comparable problems in recent years, they used the balance sheet of their governments to support their banks. Spain, for example, created a bad bank to buy up bad debts, and Ireland funded a bailout by taking the debts on to its own books.

But now banking union regulations now forbid the use of “state aid,” meaning that Italy would have to pass the costs on to depositors, many of whom are retail depositors who own bank bonds. Many more own government bonds, whose values have been under pressure as the financial viability of the banks has declined. If the new or next Italian government cannot get the rules changed or exemptions granted, and depositors effectively have to pay for broken banks, the political backlash against Rome could be even greater than we have seen so far.

Partly reflecting the slow-burning banking crisis, capital has been leaving the country in droves. Because Italy doesn’t have its own currency or control over its interest rates, capital flight doesn’t look like it would in the UK, the US or China, for example. If the monies leaving Italy for other countries due to trade, transfers and normal capital transactions exceed the monies coming in, the Bank of Italy (the central bank) has to borrow money from the European System of Central Banks, which lives under the umbrella of the European Central Bank.These borrowings are recorded by the ECB every month and normally tend to fluctuate around small margins. They are known, technically as Target 2 balances.

During the euro crisis from 2011-13, Spain, and Ireland acquired largest Target 2 deficits, which were subsequently repaid in Ireland’s case, or reduced in Spain’s. Italy’s Target 2 deficit rose sharply in 2012, but fell away significantly in 2013-14, only to erupt again over the last two years. It now stands at 20 per cent of GDP, which Italy’s highest ever deficit vis-a-vis the euro system. It doesn’t necessarily portend an imminent crisis in the eurozone, but its existence and trend point to severe financial stress.

Target 2 talk! Just like the old days….

Rachman:

It would be much harder to organise an EU bailout of Italy than it was to “rescue” Greece. Given the size of the economy, the amounts of money involved could be far larger — which would probably trigger a political revolt in the German parliament, particularly with parliamentary elections due there next September. At that point, the break-up of the euro would once again become a very real prospect.

Set against this is the Italian talent for muddling through politically and economically while always avoiding ultimate collapse. The EU seems to have developed something of the same talent over the long years of the euro crisis.

Indeed it has, but perhaps we can agree that that crisis is not, whatever Brussels might like to claim, over.