National Post (National Edition)
How Italy could bring down the euro
Italy does not fear the “lords of the spread,” according to Interior Minister Matteo Salvini. At least, not yet.
The spread in question is the difference between the cost of public borrowing for Italy versus the cost of borrowing for “safe havens” like Germany.
Monday, this spread reached a five-year high of 310 basis points. It’s going to get worse before it gets better.
Italy is barrelling toward an all-out confrontation with the euro’s fiscal authorities.
Now ruled by a coalition of populist Left and Right, the government’s new budget plans are a mix of Five Star’s promise of a universal basic income, starting with pensions, and Lega’s promised move toward a flat tax.
The result is a budget that plans to increase the government’s deficit to 2.4 per cent of GDP. This is not a huge increase from last year; it’s lower than France and is just about within the euro’s rules, but it’s three times the European Commission’s recommended deficit level for Italy and is based on the rather optimistic idea that fiscal incontinence alone will double Italy’s anemic growth rate.
The European Commission has predictably set about feeding anonymous quotes to the media about the severity of the situation, presumably to spook markets, and Rome has raged that Italy will not be frightened into submission by the “Greece playbook.”
However far this war of words escalates, Salvini is certainly right about one thing: Italy is different from Greece, Ireland, Spain and Portugal. That’s because Italy is too big to bail out.
The numbers speak for themselves. The euro bailout fund, agreed upon at such painful political cost during the height of the crisis, has a remaining lending capacity of just over 400 billion euros.
The Bank of Italy owes other euro-area central banks some 480 billion euros.
The combined value of Italian sovereign bonds held by French and German banks is around 92 billion euros.
For comparison’s sake, these same banks’ combined exposure to Greek sovereign debt around 2009, which was considered worrying enough that Greece could not be allowed to default, was less than half that amount.
These same banks are sitting on a bigger capital cushion now, but they are still desperately trying to raise yet more cash while improving profits and growing lending to boost the region’s flagging growth rate. They need a haircut on their Italian bond holdings like a hole in the head — and that’s assuming it would come without disastrous contagion effects.
The situation isn’t quite as dire as it might appear because Italy is still easily wealthy enough to service its debts. It runs a current account surplus. Yields on its 10-year bonds are at 3.6 per cent, but that’s still some way off the acute levels of 6.5 per cent to seven per cent seen at the height of the crisis and the seven-year average maturity on its debt means higher yields will only feed through slowly into much higher debt interest payments.
In other words, Italy has some time to sort itself out, so long as it doesn’t spook markets so much that it enters a death spiral of rocketing yields that make its debts unsustainable.
The problem is that the European Central Bank has been buying time with its purchases of Italian debt for six years and there’s still no sign of improvement.
This autumn, the ECB is due to start wrapping up those bond purchases.
What’s more, if Italy’s sovereign rating is downgraded too much, the ECB would in theory be forbidden from lending to Rome or accepting its bonds for collateral, potentially causing a sudden and catastrophic credit crunch.
The ultimate issue is growth, or lack of it. Italy has tried austerity to get a grip on its debt, but its populist government is quite right to complain that the austerity cocktail that was tried has failed. It has strangled growth by raising taxes while failing to reform its rigid and uncompetitive economy, dogged by inflated wages due to sectoral collective bargaining, banks weighed down by non-performing loans, illiberal professional guilds, bureaucratic courts and corruption.
As the Genoa bridge collapse showed, the country desperately needs investment. Yet Five Star’s greater electoral priority is to boost everyday spending on welfare. The noisy confrontation between Rome and Brussels disguises the truth that their interests are in fact mostly aligned. Italy and the euro will sink or swim together depending not on what budget deficit number it posts, but how much its economy can grow.
As such, the European Commission would be best advised to can the provocative rhetoric and start working seriously with Rome on a plan that prioritizes investment and structural reform. If some short-term fiscal leeway is required to make that political palatable, so be it.
Unfortunately, as we’ve seen, the EU loves nothing better than to punish its political enemies, even at the cost of its citizens’ welfare. And Salvini and Five Star’s leader Luigi di Maio won’t make it easy for Brussels.
They have defined themselves against the EU and Germany and cannot be seen to take orders or even advice from it. What makes this confrontation new is that, unlike Greece’s populist government of 2015, Rome really does have a gun to the euro’s head.
Pulling the trigger might mean blowing Italy’s own head off first, but it would be wise for the European Commission to talk Rome down rather than criticize it.