Italian Elections: Why Markets Keep Calm

The stalemate is just a palliative. The election shows that Italians are in no mood to bid for a recovery, something that must worry the European Union. A column by Fabrizio Zilibotti.

Fabrizio Zilibotti
« Markets may prefer a truce to any strong government that could produce more serious damages.»

«Is there any point to which you would wish to draw my attention?» [Inspector Gregory asked]. «To the curious incident of the dog in the night-time.» «The dog did nothing in the night-time.» «That was the curious incident,» remarked Sherlock Holmes.

After the Italian election returned a hung parliament to the third largest economy in the EU (after Brexit), the stock market has remained impassive.

Nor has the exchange rate of the Euro shown any remarkable reaction. Like the silence of Holmes’ dog, the seraphic calm of markets is puzzling. Why didn’t they plunge after such a troublesome outcome?

A simplistic and superficial argument is that markets are proving once again to be irrational. I will simply disregard such an argument. When I ask fellow economists who believe in psychologic or esoteric theories of the stock market some advice about what to buy and sell, I always get evasive answers.

Promising a «free lunch»

Let me then try to understand why the dog did not bark rather than saying…the dog should have barked but he got confused. First hypothesis: the markets had already discounted the election outcome. We see no jump in stock prices because the result was in line with markets’ expectations.

According to this explanation, the dog was anything but confused; in fact, he knew it all and saw nothing to bark at. This explanation assumes that markets are cleverer than pollsters, which is unlikely. One must acknowledge that the results of the Italian election did not come as a complete surprise.

However, there were at least two reasonable alternative scenarios. The first was an outright majority for the right-wing coalition. The second was that two old enemies, the Democratic Party and Forza Italia, would collect enough votes to sign a government pact.

The fact that neither of these scenarios was eventually realized should be news. Markets should have reacted to the fact that the least stable of the three possible outcome has materialized. Instead, there was no reaction.

Second hypothesis: contrary to the litanies of mainstream economists, the markets understood that the political platforms of the two populist parties that won the election (Five Star Movement and Northern League) are not bad. The dog did not bark because the demise of the old parties was actually good news.

This explanation is even less credible. The two populist parties disagree on almost everything but when it comes to economic policy they share the misconception that the government can make Italian people happy by dispensing them with resources that the Italian economy does not produce.

Both parties blame the EU for the constraints it imposes on fiscal policy, as if deficit spending were like the miracle of the seven loaves and fishes. Both claim that there is a free lunch that we, the blind mainstream economists, fail to see.

The form in which the Italians should enjoy this free lunch is different. The party envisaged by the Five Star Movement offers a basic income offered to all citizens, especially those who are not working. The generosity of the portions depends on the family size.

For instance, a family with two children where neither of the parents works, would receive 1,630 Euro per month. This proposal, that has a flavor of some classical leftist recipe, has obvious shortcomings.

In the  poorer areas of the countries, even working families cannot make much more than that amount, so the incentive to go permanently on welfare will be very strong.

It will also be very difficult (and expensive) to monitor abuses, such as people working in the black market and cashing-in the benefits. The proponents underestimate badly the budgetary cost of this policy, as some Italian economists have shown.

An unholy alliance or…

The Northern League offers massive tax cuts. Although tax cuts may have expansionary effects, this party has already made clear that they plan to finance them not by reducing expenditure (that would make many voters unhappy) but by increasing government debt (that is misleadingly perceived as costless).

Someone in Italy appears to have quickly forgotten that the country was on the verge of a disastrous debt crisis back in 2011. Irresponsible fiscal policy, be it right- or left-driven, may well re-open that scenario. It does not seem plausible that markets are blind in front of this risk. So, this explanation for why the dog did not bark is difficult to believe.

The third explanation is that the dog is keeping quiet because, given the options on the table, the hung parliament is the least of evils. Given the strong resolution of the Democratic Party not to make deals with either of the populistic parties, the inconclusive election results open two possible outcomes.

The first is a coalition of the right-wing cartel (or, possibly, of the Northern League alone) with the Five Star Movement. This outcome is unlikely, and even if it were to materialize, it would be fragile and ephemeral.

It appeals to neither party. The idea of a basic income is the antithesis of the right-wing voters’ abhorrence for welfare subsidies to non-working people. In addition, this policy would imply a massive regional transfer (from the North to the South, where the unemployment rate is higher), which is likely to alienate the traditional electorate of a party that still presents itself (at least in name) as a regionalist party of the North.

The Five Star Movement has also good reasons to worry about an unholy alliance with the Northern League. This party has had an especially strong turnout in the South, where many voters despise the Northern League’s leader Salvini – online, one can still watch him singing slurs against Neapolitans in 2009.

In addition, although the Five Star Movement claims not to have any allegiance to either a left- or right-wing principles, many of its supporters are disillusioned former leftist voters, who would not easily tolerate aggressive policies against immigrants or socially marginal groups that the Northern League will want to pursue.

In summary, an alliance between the two populist parties is something from which both partners have so much to lose that it may turn out to be the most promising gamble for resurrection for the shocked Democratic Party.

…a technical caretaker cabinet?

The second possible outcome is a grand-coalition with a technical caretaker government that brings the government to new elections. While such a government would certainly not undertake any important reform (in a line of continuity with the low-profile approach of former Prime Minister Gentiloni), it would guarantee a period of truce.

Markets may prefer such a truce to any strong government that could produce more serious damages. In short, the likely explanation is that markets breathed a sigh of relief. In the end, Belgium, the Netherlands, Spain, and even Germany have shown that a stalemate with the prolonged absence of an empowered government may not be so harmful.

The dog may well have been right, in the short run. Yet, the stalemate is just a palliative. The election shows that Italians are in no mood to bid for a recovery, something that must worry the European Union.

Italian voters keep going through cycles of love and hate for their politicians, with an alternation of unrealistic expectations of salvation attached to individuals and of disillusion and rejection. First, it happened with Monti, next with Renzi.

Neither of them did especially bad, but voters want more, and sooner. How long will the honeymoon with Luigi Di Maio, the leader of the Five Star Movement, last? Will he be the next scapegoat? Democracy is tricky when a country needs painful reforms that only pay off after some time.

And yet, looking at the alternatives available around the globe, it is difficult to disagree with Churchill’s view that «democracy is the worst form of Government except for all those other forms that have been tried from time to time.»