On weak footing

In the last few weeks the news were dominated by the prospect of a new Italian government. The general elections in March have left the country with a hung parliament. In the following weeks the far-right League (Lega) and anti-establishment Five Star Movement (Movimento 5 Stelle) seemingly reached an agreement between them, and seemed to be ready to form a coalition government. Their plans were met with resistance from Sergio Mattarella, when the Italian president rejected to give his blessing to the proposed finance minister. As the proposed government programme rattled the markets and was met with hostility in Europe, the President saw it right to safeguard Italian savings and reject the coalition.

Investors had a good reason to doubt the prudence of the proposed plans. While the coalition’s first draft included direct haircuts of the government debt, the modified version replaced it with a modest 170 billion euros fiscal gap, which were to be met by increased debt issuance. The proposal failed to amuse the international spectators. Foreign governments, journalists, and the markets certainly saw the red flag: the Italian national debt that is already at 130 percent of its GDP.

The main issues Italian voters face today come from the same root. Following the crisis years the ubiquitous, expensive, corrupt, and bureaucratic state apparatus had Europe’s biggest debt pile hoarded together without structural reforms. When Matteo Renzi’s government failed to curb the authority of the upper-house in a referendum in 2016, the prime minister was forced out of office. Even though the efficiency of the legislation could have been improved, the ‘No’ camp was anxious about the loss of brakes and balances in the system. The current system, designed after the fascist era, eventually prevailed; showing that history has a stronger influence on mindsets than some reformers would expect.

Seemingly the state’s efforts were proven to be inadequate to revive economic growth. Presumably, this was the main driver in the increase of populist protest votes during the last election. Although the two parties could secure half of the votes, hence the majority of the seats, longer term cooperation still seems unlikely. Both parties like to hit anti-establishment tones, however, the League was a former coalition partner to Silvio Berlusconi’s Forza Italia, which can hardly be considered as anti-establishment behaviour. The only common platform between League and the Five Star Movement are their opposition to the EU and Brussels. Both the EU and Italy would like to see the revival of the Southern economy, however, the proposed policies often create disagreement between the two largest parties.

Haircut or growth

The issue of Italian government debt has been hanging over European decision makers’ heads since the European–then demoted to Greek–debt crisis. The former problem of 345 billion euros of Greek debt looks humble compared to the Italian figure of 2300 billion euros. Today the issue reached a threshold where it can no longer be ignored or swept under the rug.

One might ask why did it become a problem now, and why it was ignored at 120 percent. In order to answer that question we must see what led to the current situation and understand how the Italian case is different from the one in Greece. Greece ended up in different shoes simply due to one unfortunate factor: their crisis unfolded before the European Central Bank (ECB) announced its asset purchasing programme. Thus, the Greek government bonds did not qualify as ‘prudent investment’ under the ECB rules. As a result, they had to be bailed out by other European member states and the IMF, while the ECB provided its emergency liquidity facility to avoid the collapse of the Greek banking system.

On the contrary, Italian bonds were worthy for getting into the basket of the ECB’s asset purchasing programme. However, due to the rules of the programme, which prohibits the ECB from buying bonds with lower yield than its own policy rate, safe German and Dutch bonds had to be excluded from the basket. As a result Italian bonds did not only qualify to be purchased, their volume even had to be overweighted to reach the monthly limit of bond purchasing. At the same time, the Italian banks that are overloaded with non-performing loans also increased their demand for ‘safe’ government bonds.

Today the rise in Italian rates causes bond prices to drop, which is painful for both the Central Bank and the domestic commercial banks. It is not surprising that the League and the Five Star Movement coalition proposed that the Central Bank should keep its government bonds on the Bank’s books. The outphasing of the asset purchases already serves as a headwind in this situation; however, the proposal just made the situation even worse. Even though there is a case for the proposal, the ECB cannot finance member states directly, thus it is unlikely to consider such action. If you can’t get a haircut only one solution is left: you must try and outgrow your debt pile. Unfortunately this solution leads to further disagreement between the Europe and Italy.

Italian populists, along with some analysts who seemingly failed their second year economic class, like to advocate the case for debt induced growth. On the contrary, the evil technocrats ‘falsely’ believe that the country might head towards a debt spiral.

Sounds good, doesn’t work

Nowadays Italy does have some economic growth, even if a snail would be considered faster than it. According to the populists’ narrative, the state could boost this pace by increasing the government expenditure. The basis for the concept comes from Keynesian economics. The theory sounds extremely compelling, yet it has a flaw: it only works under completely different conditions.

Not coincidentally, Keynesian economics became successful under circumstances where savings were too high. Correspondingly, propensity to consume were at historical lows, and national debt levels were within reasonable limits. On this hand, using credit to finance government expenditure could absorb extra savings and increase overall consumption. Moreover, growing nominal rates did not choke public finances as debt servicing remained low due to low levels of overall debt. On the other hand, what we see in Italy today is different. Savings are at historical lows and the economy needs external sources to finance itself. Personal consumption is growing without intervention. Furthermore, one percent increase in interest rates would widen the government deficit with an extra 1.3 percent compared to GDP. Given these condition a failure can be almost certainly predicted.

Instead of advocating for an idea which is easy to sell but impossible to work out, Italian politicians should rather understand the reason behind the current growth and leverage on those factors. In the last four years Italy’s current account balance has reached a surplus. This is not due to currency manipulation or supportive monetary politics. In fact, Italian exports became more expensive compared to import prices during the same period. Consumption of foreign goods did not drop. Furthermore, internal wage dynamics did not provide any competitive edge either. Unit labour costs, a common measurement of the price of labour within the economy, also showed a slightly increasing trend. The only possible explanation to the phenomenon is simple: foreign demand for Italian goods increased during the last three years. The existence of this surplus is not merely a crucial driver for economic growth. Having a positive balance also decreases the economy’s dependence on foreign funds and supports its net international investment position. Conclusively, the decrease in foreign funding could secure the economy’s independence from prevailing investor sentiment, which would make public finances more resilient against international fluctuations.

For a government that is trying to pick a fight with foreign political powers, maintaining these trends should be a priority concern. Instead, their proposed policies aim to reverse these trends and implement new policies that are doomed to fail. Growth is hanging on a thread, and they are planning to cut it. Luckily, there is nothing set in stone yet. It is still possible to avoid Italian bankruptcy and the collapse of the monetary union. However, the European foot with a populist power in the Italian boot could shake easily.