Italy and other South Europeans remind me of someone I know. He is lazy and dropped out of school. He can't make much money but overspends what he has. Fortunately, he has a rich uncle who loans him money to save him from the loan sharks. The uncle always urge him to go to night school and spend less - advice that he resents.Dear Prime Minister Conte,
Congratulations on forming a government, at last. Now you can start on the agenda of your power brokers at the League and 5 Star Movement.
I realize you face a tricky political situation at home as you try to shepherd a fractious coalition with a slim parliamentary majority. And you might be looking to Europe for the real opposition, as Germans, in particular, are deeply uncomfortable about your coalition’s plans for a huge budget deficit.
You should instead be looking at the bond market, which poses the true threat to your agenda. If you can keep the bond market calm, Brussels has little legal, moral or political ability to force Italy to follow fiscal rules. Only if the bond market repeats the blowup of 2011-12 does Europe gain the upper hand.
And here is where things get complex. The explosion of bond yields last week—with the biggest one-day rise in short-dated yields since at least 1989—shows that investors’ real concern is that Italy might leave the euro. So long as you can convince the markets that they won’t be drenched in freshly minted lire, you will be fine. Dropping the plan for “mini-BOTs,” low-value bearer bonds that look to some like an alternative currency, would help.
You can report some progress. Firebrand League leader Matteo Salvini has stopped railing against the euro, focusing instead on Europe’s failure to help Italy with a wave of immigrants. The “Basta euro!” (Enough euro!) sign outside the League headquarters has been whitewashed. Still, while Mr. Salvini might have accepted the shift of euroskeptic Paolo Savona out of the finance ministry, making Mr. Savona Europe minister is a recipe for confrontation.
At this point, Europe’s main concern is that you’ll follow through with the League and 5 Star’s fiscal promises, which would cost upward of €100 billion (about $120 billion) a year and flout the fiscal compact Italy signed in 2012. The worst the European Commission can do is issue a fine of 0.2% of GDP, or about €3 billion, but that has proved toothless in the past. Fines threatened against Portugal and Spain were never imposed, and France was in breach of the rules from 2009 until earlier this year without being fined.
Even if the Commission developed a spine, fining Italy would surely help the euro-doubters in your cabinet convince the general public of their claims that Europe has it in for Italy, as Daniel Gros, director of the Centre for European Policy Studies, points out.
A full-on fight with Europe might raise doubts about Italy’s ability to stay in the euro. But you should worry more about the bond markets.
They don’t care about European rules, which make little sense anyway with their arbitrary 60% cap of government debt to GDP. They do care whether Italy is able to sustain its vast pile of debt in euros—money that the Italian government cannot print in an emergency, unlike lire. Convince investors that you will boost long-term growth, and they will accept some deficits in the meantime, although not as much as all the coalition’s promises would require.
Unfortunately, your coalition’s other policies offer scant support for the idea that the economy will get anything other than a short-term boost. Perhaps it was significant that you didn’t mention plans to reverse pension reform in your speech this week, but it would be wise to talk a lot about the few areas where reforms were promised, such as the legal system.
The alternative is just to run a smaller deficit. Few will panic if you boost the budget deficit by a couple of percentage points. It would be easy to phase in spending and offset some of the cost of the lower “flat” tax rates by broadening the tax base to reduce the impact on the deficit.
Former Fitch Ratings head of sovereign ratings David Riley, now chief investment strategist at BlueBay Asset Management, says that “outside emerging markets, bond vigilantes haven’t been very vigilant when it comes to fiscal policy, so how aggressive would they be on Italy?” He thinks you could get away with a 3%-4% deficit, compared with 2.3% last year, especially if you managed to boost growth. But that would still require hard decisions on watering down coalition policies, cutting spending or raising new taxes.
The rating agencies watch deficits closely, and a downgrade to junk bond status would be catastrophic for Italy’s ability to raise finance by making its debt unacceptable to the European Central Bank. But to be junked by all the major rating agencies usually requires a country already to be in very serious trouble; Portugal got by on a single investment-grade rating from Canadian agency DBRS for years. The rating agencies are unlikely to be the cause of a crisis.
If you lose faith with the bond market, you give Europe the upper hand. As Guntram Wolff, director of think tank Breugel, says: Italy is just too big, and the options “become very quickly very nuclear.”
The rescue funds used in the last crisis to keep Greece, Cyprus, Spain, Portugal and Ireland going are too small to support Italy. The ECB has the firepower but also has a record of making big demands for austerity and reform. Silvio Berlusconi even blames an ECB-led plot for his exit from the premiership in 2011. If you have to beg for help, the League-5 Star policy program is toast.
The rich uncle is Germany in the case of Italy. The loan shark is the market and the advice the uncle gave him is the "reform and austerity" package the EU imposed.
The problem is that people want more goodies from the government but don't want to pay for them. (Promising the voters more spending and lower taxes will always win elections! Responsible politicians rarely get elected.) They expect somebody else to pay for them. That is why all governments have budget deficits. What should the EU do with regards to Italy?
Throw them to the shark! By this, I mean throw them out of the Euro. Let the Italians go back to the Lire and be discliplined by the market. The Lire will plunge making Italians poorer. Their standard of living will fall to a level that is in line with their skills and productivity. That sounds fair to me. Of course, German banks will lose a lot of money because the Italians won't be able to repay them. But that will serve the Germans right for lending them money so that they can buy German exports. Everybody gets what they deserve.