The Italian puzzle

Should the leaders of the two governing parties, Salvini and Di Maio, enact only a portion of their programs, Italy would sink in a major economic and financial crisis. A column by Charles Wyplosz.

Charles Wyplosz
«Italexit can be achieved in two ways. One possibility is for the Italian government to decide to leave, British style. The other possibility is to be expelled in the midst of a major financial crisis.»

On one side of the podium, you can see the leaders of the two parties that won the Italian election and agreed to form a government. On the other side, you see the Finance Minister, who is not a politician, just a relatively unknown professor of economics. Nowhere to be seen is the Prime Minister, not a politician either. It matters a great deal who will make economic policy decisions over the next few months.

The reigning duos, who appointed themselves Deputy Prime Ministers, are hard-core critics of the euro. Beyond that, they disagree on most issues but managed to unite behind an economic program that includes sharp income tax cuts (the replacement of the current progressive system by a flat tax) and a universal «citizens» income, the hiring of 10’000 civil servants. They also want to allow earlier retirement with higher pensions. They already rolled back the most important reform enacted in Italy over the last decade, Renzi’s Jobs Act, which had introduced a bit of flexibility in one of the world’s most rigid labor markets. Should they enact only a portion of this program, Italy would sink in a major economic and financial crisis.

Professor Giovanni Tria, the Finance Minister, is keen to project a measured sense of responsibility. He has decided, he said, to stick to budgetary orthodoxy. The economic slowdown, which affects Italy a bit more than most other Eurozone countries, already implies an increase in the deficit, but a modest one. He seems ready to tolerate such a slippage but not more. How then does he intend to implement his two political bosses’ promises?

Between despair and wishful thinking

He claims that he will, taking advantage of the acceleration of growth that, for sure, must be around the corner. He also plans to find some room for maneuver by constraining most public spending and getting rid of the myriad of tax loopholes that drain public revenue. This is the classic optimism of weak Finance Ministers, which combines the promise of an imminent growth rebound and the ability of better controlling the budget that his predecessors failed to do. He also seems confident that he will be blessed by the understanding on the part of his bosses that «Rome cannot be built in one day».

The Italian elite, which has been soundly rejected by the voters – much in the same way as the elites in the USA, Britain, Germany, Austria, Hungary, Poland, etc. – keep oscillating between despair and wishful thinking. After the elections, they expected the President to call for new elections that would bring the elite back into power. Then they were sure that Matteo Salvini, the leader of the far-right Lega, and Luigi Di Maio, his colleague at the head of the anti-elite and leftish Five Stars Movement, would never agree to form a government, opening the way for a minority government between the moderate right and left.

Now they bet on Professor Tria’s powers of persuasion. The thinking is that Salvini, the alpha male of the reigning duo, will be satisfied, and will satisfy his electorate, by keeping himself busy with spectacular and tough anti-immigration policies. This would leave Di Maio, who contributed much of the economic nonsense to the agreed-upon program, unable to force the hand of the Finance Minister. Maybe.

A «Greek» scenario?

But maybe not. The deal could look very different: Salvini gets a free hand on immigration and Di Maio has his say on economic policies. Before the electoral campaign, both had proposed to leave the Eurozone first, the EU next. Then, they toned down their ambitions to avoid losing votes in a country that was a founding member of the European Community upon the signing of the Treaty of Rome in 1957. But Italexit can be achieved in two ways. One possibility is for the Italian government to decide to leave, British style. The other possibility is to be expelled in the midst of a major financial crisis. The government program is a sure way of achieving the second path to Italexit.

It is fairly easy to imagine this scenario. It starts with the implementation of the promised reforms. The budget deficit soon swells. The Commission deploys its bureaucratic arsenal while anguish mounts on the financial markets. It becomes increasingly more expensive for the government to borrow and its bonds lose value. The Italian banks, which own directly or indirectly almost 70% of these bonds and are often fragile, struggle to absorb these losses. Owing to German opposition over the last few years, there is no collective bank deposit guarantee in the Eurozone. Italian bank depositors conclude that their money is endangered and withdraw large amounts of funds to ship them abroad, including to Switzerland by the way.

Italy now faces the most lethal combination of a debt crisis and a bank crisis. It looks like Greece in 2010, but with a huge difference: Italy is several times bigger than Greece. Because a bank crisis could rip through the global financial system, one way or another it must be bailed out. With some € 500 billion available, the Eurozone’s rescue fund, the European Stability Mechanism (ESM), is likely to be too small. The ECB, which faces no limits, can be called to the rescue, but it may only step in if Italy has previously obtained a loan from the ESM. Such a loan is conditional, though. The Italian government must agree to tough conditions, essentially the undoing of everything that they did. Will they?

Financial markets will keep an close eye on Italy

This scenario is on everyone’s mind, which is a good reason why it will not happen. Nobody wants to reach the point where the question above must be answered. Not the Europeans, not the banks, not the Italian public. What is unknown is whether the Italian government would be glad to seize the occasion and leave the EU. They might be deterred by what happened in Greece after the election of the anti-elite leftist Syriza party. Its first Finance Minister, Professor Yanis Varoufakis, enjoyed a few months of glamorous provocations but, when the brink was reached, he was fired. Since then, Prime Minister Alexis Tsipras has become of the most docile customer of the ESM. Maybe the right question is: what would you do if you were Salvini or Di Maio? The problem is that you can’t be both of them and each of them probably does not know what he will do.

Where does this leave us, then? We are staring at the scattered pieces of a very big puzzle. Fairly soon, though, the pieces will have to be put together and the picture will emerge. All the actors will have to be positioned. The Italian political leaders will start outlining their economic policies and making more precise their intentions. The other European governments will have to decide what they can accept and what cannot be tolerated. The European Commission will have to produce formal evaluations of the Italian government’s present and future decisions. The ECB will indicate how far it can go if the Italian banking system tanks. The financial markets will observe the image coming out of the puzzle and, if they do not like it, boom, we will have a crisis.