Italy’s coalition has potential to drive EU into a depression
DESPITE the 11th-hour agreement to form a new government in Rome, Italy still has the potential to send Europe into depression if the costly promises made in the election campaign are kept and long overdue and difficult reforms further postponed.
The Italian government debt is 130pc of GDP. If the financial markets lost confidence in an Italian government’s ability or willingness to service and roll over this debt, there could be a rapid series of events leading to Italy’s exit from the euro and widespread loss of confidence in the bonds of indebted countries.
What could trigger this?
The parties in the new Italian coalition government, Five Star and the League, promised during the election to reverse a recent VAT increase (cost €12.5bn); to introduce a flat tax (€50bn); to introduce a basic income (€17bn); and to scrap a recent pension reform (€8bn).
These measures could bring the budget deficit from its present 1.9pc of GDP to a staggering 7pc of GDP. That would create a financial crisis. It would break EU rules too.
It would also impoverish Italian voters. Despite years of low growth, the average Italian household still has more net wealth than the average German household. But a lot of that is tied up with the Italian banks and their bonds.
Overall, two-thirds of Italian government bonds are owned by Italian residents, including banks, so many households would be suddenly impoverished if these bonds were devalued. A sudden rise in interest rates in Italy would devalue bonds that had been issued at a lower rate of interest.
Some 48pc of bonds are held by Italian banks. A loss of confidence could destroy some banks’ capital base, leading to a run much like the Northern Rock situation in 2012.
The European Central Bank (ECB) could step in to stop such a crisis. It has power to buy Italian government bonds under its Outright Monetary Transactions (OMT) programme, but it can only be brought into operation if the Italian government has first applied for help and signed up to a tight austerity programme. The present administration would have difficulty agreeing as this would go against its election promises.
However, the ECB would have to
insist on the austerity measures otherwise it would be simply sending good money after bad, something that would not appeal to European taxpayers who are the ultimate owners of the ECB.
For the past 10 years, Italian politicians – including the parties who lost the recent general election as well as those who won – have been blaming the constraints of euro membership and the disciplines supposedly imposed by Brussels for the sluggish performance of their economy, and for the fact Italian wages are still far below what they were in 2007.
BUT, as a recent IMF study shows, the reasons for stagnant incomes in Italy are to be found in Italy itself, not in Brussels. Since 2000, the total factor productivity of the Italian economy has fallen by 6pc, whereas productivity in Spain has risen by
2pc and in France by 4pc. Since
2000, investment has risen by 10pc in Spain and by 20pc in France, while it has fallen by 15pc in Italy.
France and Spain are in the euro too, so membership does not explain Italy’s under-performance.
Italy’s problems derive from a number of factors. One is the big increase in spending and debt levels that took place in the 1980s.
Its administrative and legal systems have also inhibited the reallocation of Italian talent, money and effort from less productive to more productive activities.
The arteries of the Italian economy are blocked by a sluggish parliamentary and courts system, by out-of-date insolvency laws and by a bloated public sector. Wages are set centrally with little regard to the profitability of individual firms. A lot of capital is tied up in zombie businesses, many state-owned.
Reforms have been made to liberalise the labour market and the professions, but these will take time to yield results and are insufficient on their own.
Italy is a rapidly ageing society, so the proposed reversal of the recent pension reforms would worsen the situation. On the other hand, the new government’s flat tax and basic income proposals could, if combined with radical measures to combat tax evasion, remove tax shelters and improve work incentives and overall efficiency.
Euro membership has prevented Italy from using devaluation to restore competitiveness at the price of higher inflation.
Older Italians have benefited from this. Italian savers (mainly older people) have been protected from the devaluation of their savings, through inflation, that took place before the euro.
But the failure to free up the economy through structural reform has meant job seekers (mainly younger people) have suffered. Many talented young Italians have emigrated, some to Ireland.
The new government could tilt the balance in favour of young Italy, and attract those young people home if it combined its popular tax and welfare plans with much less popular but equally urgent reforms to administration, the courts, wage setting, insolvency and pensions.
The first big test will come in October when a budget has to be presented. That is when the new government’s real priorities will be revealed.