Following three months of political turmoil that roiled European — and especially Italian — financial markets, an agreement to form a new government in Italy now looks all but certain. The left-wing party Five Star Movement and the far-right Northern League renewed efforts to create a populist government with cooperation from other key Italian officials. Stock markets rallied on the news and yields on Italy’s 2-year bonds declined nearly a full percentage point as investors gave a sigh of relief.
But the situation appeared far more dire earlier this week when it looked like Italy could not form a coalition government after its March elections. Italian stocks – especially bank shares – and bonds sold off as investors looked for clarity in a potential chain-reaction situation. The underlying problem: a slow-growing economy, which, along with anti-immigration sentiment, is reshuffling Italian politics. That led to the immediate trigger for the recent turmoil — and these problems could resurface again.
“Bond markets show money moving out of Europe, out of sovereign debt instruments – and not just in Italy, in the Eurozone as a whole,” said Erik Jones, a professor of European studies and international political economy at Johns Hopkins University. He joined Federiga Bindi, a professor of political science at the University of Rome Tor Vergata, to discuss the issues on the Knowledge at Wharton show, which airs on SiriusXM channel 111. (Listen to the full podcast using the player at the top of this page.)
This has raised fears of a Greece-like financial crisis returning to Europe, and possibly spreading beyond, though financial markets recovered somewhat after being on a knife’s edge earlier in the week. The situation recalled the bad days of 2011 and 2012 when Italian bond yields soared to default-threatening levels that could topple banks – and the whole economy — and drag the region into the mire. That was before Mario Draghi, the European Central Bank (ECB) president, made the bank the lender of last resort. Until then, the absence of such a backstop was a glaring omission of financial insurance that risked allowing a new financial crisis to outrun governments’ ability to supply remedies.
And talk that was prevalent two years ago about a so-called “doom loop” has also revived. This doom loop can arise because many top Italian banks, already shaky by virtue of carrying large amounts of bad loans, also hold hefty portfolios of Italian government bonds, which are considered high-risk debt. When prices of those bonds fall, as has been generally happening recently, the banks could need more government money to shore-up their capital.
Financial stress multiplies because the government is already so indebted that borrowing more money to fund shaky banks means yet more risk for investors, and that reduces the value of existing bonds, which in turn further reduces the value of the banks’ government bond holdings. The banks, in theory, then have to get yet more support from the government. That cycle – or loop — continues in a downward spiral that threatens to end in bank runs and the need for a bailout of a financially crippled Italian government. Not only would this risk instantly spread to other European countries — and beyond — but Italy’s economy is so large that it could jeopardize the ability of the ECB (combined with the European Stability Mechanism and the International Monetary Fund) to bail it out and stop the cycle.
As the Financial Times noted, “A key fear for investors in Italian bank bonds is that the growing political turmoil will derail efforts from the country’s lenders to dispose of bad loans that have long weighed down their balance sheets.”
“This represents yet another serious setback for Europe.” –Mauro Guillen
It was also widely reported that George Soros, founder and chair of the Europe Open Society Foundation, and a fervent supporter of Europe, said in a speech on May 29 that the EU could be facing an existential threat due to the latest crisis and that, more generally, the rising dollar and hot money exiting emerging markets have greatly increased the risk of a new financial crisis. In Europe, he said, “everything that could go wrong has gone wrong.”
As one gauge of the seriousness of the situation, Reuters was serving up headlines like this one: “Investors ask if ECB has will and means to save euro from Italian turmoil.”
Given that Italy is the European Union’s third-largest economy – about 10 times the size of Greece’s — big problems there would be devastating. Speculation that financial disruption could lead to Italy leaving the Eurozone or ditching the euro – however tenuous — has also crept back into the conversation.
A Worrisome Backdrop
And it’s not just the problems in Europe threatening more global economic and financial volatility that cause worry. “This comes at a bad moment,” said Wharton management professor Mauro Guillen. “We have an ongoing trade ‘war’ between the U.S. and China, unresolved tensions on the Korean peninsula, and the unfinished Brexit negotiations in Europe.”
Italy’s economy continues to suffer from a lackluster performance and “most importantly from a very difficult political situation in which a major EU economy is teetering on the verge of populism,” Guillen said. “The issue is that it brings instability, and the markets are reacting very badly for that reason. This represents yet another serious setback for Europe.”
According to Wharton finance professor Joao F. Gomes, the risk of an unintended financial implosion with repercussions in European and international markets “remains very low. But we will go through yet another very disruptive year which will greatly damage the Italian economy and perhaps derail the recovery in Europe.”
‘Beyond Rationality’
The immediate cause of the return to turmoil in Italy was the failure of the two parties that won the most votes in March elections to form a new government — the far right Northern League and the leftist Five Star Movement — noted Bindi during the radio show. The parties had many differences, but were thwarted by outside players as they tried to create a governing coalition, she added.
When their fledgling coalition proposed making Paolo Savona finance minister, Italian President Sergio Mattarella quashed the idea, Bindi noted. In effect, that prevented the two winning parties from forming a government and led to Giuseppe Conti, the coalition’s proposed prime minister, to end his efforts to do so. It then turned out that nixing Savona, rather than calming markets, roiled them further and led to the substantial sell-off earlier this week.
Some analysts said Savona’s past anti-EU rhetoric worried Mattarella about creating damaging tension in financial markets. Instead, Mattarella proposed having Carlo Cottarelli, formerly with the International Monetary Fund, work out a caretaker government. Both Five Star and the Northern League rejected that, leaving no clear path to forming a new government and making it likely there will be new elections in the fall (although there had been some efforts to revive a coalition and avoid new elections).
According to Bindi, Cottarelli is highly qualified, but because he worked for the IMF, “he represents everything the Five Star and the League are fighting against” policy wise – meaning external controls. “I could not think of a worse choice for a PM-designate in this particular moment.”
“[Economics] is the main — actually the only — issue.” –Joao F. Gomes
As for elections, it’s even possible they could be called for August, when many Italians are away on vacation, said Bindi. If that happens, all bets are off, she added. No one could predict the likely results.
“We are beyond rationality at this point … the debate is going to get uglier and uglier,” she said. “The biggest mistake was to push Five Star and the League together. What unites them is being anti-system, anti-euro — the door has been opened and we don’t know where this is going to lead.”
Both parties have made it clear they think that Eurozone rules for member economies are too restrictive. Specifically, economic growth in Italy has been slow for decades, and Five Star wants more government growth policies, which would almost certainly violate Eurozone debt-limit requirements. The signature issue for the Northern League, meanwhile, calls for far stricter immigration policies.
Evaporating Patience
With high government debt and the added constraints of Italy not having control of its own currency, there’s been insufficient government action to try to offset the economic stagnation, some analysts argue. Although there has been some modest economic pickup over the last three years – last year’s 1.5% GDP was a weak highlight – Italian living standards are basically stuck where they were 20 years ago. Youth unemployment is still well above 30%. That has been a big problem for decades.
Over the last couple of years, following a rough patch after the financial crisis and the austerity policies required by the Eurozone, the patience of many Italians has finally evaporated, driving them away from mainstream political parties. All of this has been made more difficult by the costs of the immigration crisis, particularly in a country where unemployment has been high for years. As was the case in France, non-traditional parties in Italy stepped up with alternate approaches.
Italy’s March elections were the culmination of all of this, given that the two leading vote-getting parties voiced opposition to many Eurozone policies.
But not everyone agrees that the March election results flowed from a desire to cast off restrictive economic policies. “I would not necessarily say that this is the result of continued austerity policies,” noted Guillen, who is also director of the Lauder Institute. “That has perhaps persuaded some voters to support populist parties or movements, but it is also dissatisfaction with the other parties.”
On the radio show, Jones said voters do make some connections between the euro and EU on the one hand, and a feeling of frustration of abandonment over a huge migration problem and slow growth, on the other. But “there is not a widespread movement in Italy either to leave the EU or the euro.” The two parties did not campaign directly on leaving the EU leading up to the March elections, Jones pointed out. “These are issues that came up after the campaign and crystallized last weekend, but I would not say they represent a groundswell of opinion.” What’s more, the biggest wave of immigrants landing in Italy crested almost a year ago, so if anything some pressures are receding.
Nevertheless, some observers worry that the political chaos will in some way create pressure to leave the Eurozone, however unlikely such a move may be ultimately. For example, if there were new elections, some parties might choose to campaign on pulling out. Regardless of the outcome of any exit question, financial markets would be negatively affected in the run-up.
“If you get help from the EU, and then the EU puts conditions on top of that, that would stabilize the situation economically, but politically make it much more challenging.” –Erik Jones
“I completely agree that economics is the main — actually the only – issue,” said Gomes. “But austerity is the wrong word to characterize the current situation in Italy.” Instead, a fundamental problem is that “the Italians really want debt forgiveness — and most of that would come from the Germans.”
Bindi explained that many Europeans – rightly or wrongly — say “Germany has been profiting from the crisis rather than helping” to solve it.
According to Gomes, it is unwise “and arguably even ungrateful to criticize Germany for its unwillingness to guarantee — and possibly bankroll — yet another spending spree.” He sympathizes with the view that Europe overall does not need more austerity, but Italy has a debt-to-GDP ratio of over 130% and “needs to be realistic about its ability to borrow in international markets without a guarantor of sorts.”
In Gomes’ view, southern Europe is unwilling to accept that they “cannot continue to be so unproductive.” He sees three options for the region: Reform the economy in order to increase productivity, leave the euro altogether or “become dependent on the handouts of the more successful countries.” And while the ECB has effectively done some of this behind the scenes, the last option “seems mostly exhausted for the moment.”
Jones, who is also co-chair of Research Network on European Integration and the Global Political Economy, added that if the pressure increases enough, the Italian government might have to ask for EU assistance. “That could transform a non-issue into a real issue, because if you get help from the EU, and then the EU puts conditions on top of that, that would stabilize the situation economically, but politically make it much more challenging.”
