In the end it happened: after a lengthy process and some coups de théâtre, Italy’s two populist parties, the Five Star Movement (M5S) and the Lega, have managed to form a government.
Their route to power was nearly thwarted by a constitutional dispute in which Italy’s president, Sergio Mattarella, refused to accept the two parties’ original nomination of Paolo Savona as economy minister. Savona, an economics professor, had outlined in a 2015 conference a “Plan B” on how to exit the eurozone, which contained the striking statement that no popular vote or referendum would be required.
Mattarella explained that he had rejected Savona’s nomination because the post required a “representative of the majority”, who “may not be seen as the promoter of a line of reasoning, often manifested, that could probably, or even inevitably, provoke Italy’s exit from the euro”.
The constitutional stalemate has now been solved by moving Savona to a different ministry – EU affairs – and appointing an alternative economy minister, a professor, Giovanni Tria. He has been judged to be less inimical to euro membership, despite being broadly critical of the eurozone’s functioning.
The key two key questions for Italy now are: first, whether the new government’s fiscal stimulus plan is compatible with eurozone rules; and second, whether Italy’s quest for “fiscal sovereignty” is really being thwarted by euro membership.
Italy in the eurozone
Let’s start with the second question. By joining the eurozone, Italy lost its ability to devalue, and there were fears that its trade balance would deteriorate. As we know from the UK, however, having your own floating currency does not necessarily translate to a trade surplus.
In any case, Italy’s competitive position has arguably improved markedly in recent years. Following a period of trade deficits during 2002-11, since mid-2012 the country has been running a healthy trade surplus, thanks to a major surge in export growth.
Italy has also benefited hugely from much lower interest rates since joining the euro. In 1992 Italy’s ten-year bond yields were around 7.5 percentage points above Germany’s. By monetary union in 2002 the gap was around 5.1 points.
Last week, despite the political crisis, Italy’s treasury was still managing to issue ten-year bonds at 3%, around 1.6 points above German bund yields. Yes the spreads were much higher in the wake of the eurozone crisis, but they have since been driven down, thanks to the European Central Bank’s quantitative easing, creating a boon for the stretched Italian exchequer in the process.
Italian ten-year bond yields, 1990-2018
So let’s do an economics Gedankenexperiment. What would happen if Italy were able to wave a magic wand and leave the euro overnight? We’ll set aside the practical complications of achieving this – though they would make Brexit look like a walk in the park.
A major rise in bond yields to pre-euro levels would be almost inevitable, thus sharply increasing the government’s interest repayments on its debt over time. With government debt currently at 132% of GDP, this would quickly make Italy’s fiscal position unsustainable. It would lead without doubt to problems of refinancing, triggering a debt restructuring. Even a hike in yields to the level seen during the 2011 eurozone debt crisis would be catastrophic. (Interestingly, the ECB scaled back its proportion of debt-buying aimed at Italy last month, in what might be seen as a signal of its concerns.)
One result would be that Italy’s banks would fail: about 60% of Italy’s treasury debt is held by the country’s residents, three-quarters of which are in holdings in Italian banks. A substantial burden would fall on Italy’s poorer socioeconomic groups who don’t have the means to diversify their wealth. Plan B suddenly looks like Plan Z.
Then there is the question of whether the incoming government’s spending programme is compatible with the eurozone’s fiscal rules. The programme suggests increasing annual spending by between €107 billion and €126 billion (£94 billion to £110 billion), including around €50 billion to introduce a “quasi-flat tax” of 15% on individuals’ income and 20% on companies; and €17 billion to introduce a “citizen’s income and pension”. On 2017 figures, this is a fiscal stimulus of around 6.3%-7.4% of GDP – well outside the parameters of the eurozone’s fiscal rules.
You also have to ask what this fiscal expansion is trying to solve. Italy’s main problems are slow economic growth, inequality (though that increased mainly in the 1990s) and particularly youth unemployment and underemployment.
These difficulties are mainly attributable to stagnating productivity growth. Increasing annual spending by cutting taxes and increasing welfare spending would not kickstart productivity growth. Also, bear in mind that both the quasi-flat tax and the universal untargeted welfare spending are likely to be regressive, shifting more of the overall tax burden on to the poor – hardly lessening inequality. And if these tax and pension giveaways are, even in part, financed by increases in indirect taxes such as VAT, that would be even more regressive.
Many economists have been critical of the design of the eurozone fiscal rules. I have argued in favour of redesigning the system – above all that the monetary union requires political oversight and also better risk-sharing through elements of fiscal union.
This could be achieved through the type of reform agenda which the French president, Emmanuel Macron, has been advocating, which would include a joint eurozone budget, a post of EU finance minister and a new body to oversee EU economic policy. Or equally there could be some reform of the eurozone fiscal rules which would allow some room for manoeuvre in the short term to individual countries facing macroeconomic shocks not shared by the rest of the zone. At present this is anathema to Germany and its EU allies.
Is this déjà vu? Yes. It’s another version of David Cameron’s pre-Brexit negotiation, which arguably set back EU reform by years.
The problem is that the M5S-Lega agenda, far from encouraging such much-needed reform, will trigger more resistance to change among eurozone fiscal hawks. The irony of course is that Italy could not afford this populist profligacy even if it were outside the eurozone. Yet whether the EU’s overseers can afford to reject these plans from Rome without at some point reforming the existing system is another matter entirely.