A coalition government came to power in June, but its views on the euro, fiscal policy, and the European Union have rattled global financial markets.
Italy’s new populist government, consisting of the antiestablishment M5S and the far-right League party, was sworn in to power by President Sergio Mattarella in early June. Giuseppe Conte, who is backed by M5S, became the new prime minister. The government was formed after three months of political deadlock in the eurozone’s third-largest economy following inconclusive March 4 elections. In late May, the coalition reached a last-ditch deal amid growing global market turmoil. The coalition has won mandatory confidence votes in Parliament.
An unlikely marriage
Conte and the fringe parties ascended to power after the elections pushed aside mainstream political groups. The coalition between the left and right seemed disconcerting and dubious. But the two found themselves in this unlikely marriage. Early on, there were disagreements over forming a government, and President Mattarella vetoed the coalition’s choice of a eurosceptic economist who advocated a “plan B” to leave the euro. The government’s views on the euro, fiscal and economic policies, and the European Union, among others, have rattled Italian and global financial markets.
The populists driving the political bus have various economic proposals. If enacted, they would raise the fiscal deficit, lower potential growth, and worsen Italy’s debt. Other ideas include the European Central Bank (ECB) writing off its holdings of Italian government securities (BTPs) and leaving the eurozone. There are Italians who describe the euro as a “German cage.” The full implementation of the proposals is simply incompatible with membership in the eurozone. The ECB cannot write off its BTP holdings as a gift to the government.
Delicate dance with the EU
So, what will happen? The coalition government will make a show of trying to implement some reforms, and there will be a delicate dance between Rome and its partners in Brussels and Berlin. This will not encourage stability in Italian asset prices. We anticipate the populists will rein in their policy ambitions and the eurozone will throw them a bone by temporarily relaxing fiscal rules. The long-term political stresses will remain; the underlying economic weakness, disillusion with the EU, and resentment toward Germany over migration policy will not dissipate.
The M5S and the League are not natural bedfellows, and it seems likely to us that the government will collapse. Opinion polls suggest the League has gained popular support, creating an incentive for it to seek new elections to increase power.
Growth and debt woes
Italy needs growth driven by a better economic structure and not by fiscal relaxation. Without that growth, it remains vulnerable to higher interest rates. Rising risk premiums on local debt will slow growth. Italy’s economy, unlike that of Portugal, Greece, or Ireland, is large enough to matter to the eurozone. It will not take much to push Italy into a crisis given its debt. The public debt is 130% of gross domestic product, and the debt dynamics are about the relationship between growth and interest rates. Inflation is around 1%, productivity growth is around zero, potential growth is estimated at less than 1%, and realized real growth over the past 20 years was barely above zero.
Italy’s size creates a new European dimension to this problem. The Europeans have put in place various policies since the last sovereign debt crisis that enable them to deal with a small country. But they can’t deal with Italy. The ECB supervises large Italian banks, and this cuts off, or dramatically reduces, the scope for the traditional route of easing a sovereign debt problem by stuffing bonds onto the books of local banks. Italy also makes it impossible to agree on the next round of eurozone reforms.
Against this backdrop, it’s hard to believe that Italian assets — at least BTPs — are fairly priced. We think the default risk on BTPs is materially higher than it is for Greece or the other bonds included in the JPMorgan High Yield Index. The 10-year default probability in Italy is forecast at over 10%. During the last eurozone sovereign debt crisis, we used a country’s TARGET2 balance as a stress indicator. These balances aren’t the cause of the problem, but they do reflect its dimension. Germany’s position is now much larger than it was in 2012, and Italy is running the biggest deficit. We need to think about what is going on in Italy, and how serious a threat it is to the European and global outlook.
Next: Interest-rate ripples