4 March and the end of the euro

So far, Europe’s election season isn’t a complete disaster. But that could all change on 4 March. Because the Italian election could be the only election that matters.

Italy’s financial situation is in tatters. The banking system has a bad debt problem the size of the Greek sovereign debt crisis of 2012. And the Italian debt-to-GDP is at the levels that got Greece into trouble. But with a total debt that’s ten times the amount.

The outlook is even worse. Despite near 0% interest at the European Central Bank (ECB) and vast amounts of quantitative easing (QE) buying up vast amounts of Italian debt, the country spends about 4% of its GDP on interest for government debt. Thanks to GDP growth at about 1%, without improvement on the horizon, and a deficit above 4% of GDP, escape from the debt trap is looking mathematically impossible.

So what’s politics going to do? Make things worse, of course.

So far, the Italian voter is matching with the British, American, French, Dutch, German, Hungarian, Austrian, Czech and others. They’ve dumped the mainstream parties and turned to… well, anyone else. Even Silvio Berlusconi’s party, despite him being banned from office.

In Britain, Brexit was a surprise for the EU establishment. The Czechs and Hungarians are also serving up problems. In Austria, a eurosceptic party made it into coalition. And in Germany, mainstream parties are having to form a coalition to keep the Alternative for Germany (AfD) party out. Nobody knows quite what Donald Trump is thinking. The Dutch and the French elections didn’t serve up much trouble though.

What makes Italy’s elections so remarkable is that the mainstream parties could disappear altogether. Instead, four newcomers have surged into the running. Despite the fact that even the current government’s policies are extreme.

The governing Democratic Party has less than a quarter of the vote in the polls. After the election, it wants to abolish the EU’s rules on budget deficits and raise the budget deficit to 3% of GDP for five years as a stimulus. That would mean a spike in the dangerously high debt-to-GDP level.

From here on in, it gets even wilder.

The 5-Star Movement is in the lead with just over a quarter of the vote. This upstart party is full of colourful personalities and disjointed policy proposals. It wants to renegotiate the EU rules restricting budget deficits and spend far more to stimulate the economy. If it doesn’t get what it wants from the EU, it’s in favour of a referendum on euro membership. Is it a negotiation tactic or a genuine threat? It’s topping polls, so we may find out.

Berlusconi’s Forza Italia doesn’t seem troubled by the fact that its leader is banned from office. His reinvented party could still take power in a coalition deal. He’s steadily made his policies more and more moderate to attract voters.

Berlusconi’s latest pitch is to introduce a parallel currency for domestic use to boost the economy, but keep the euro for international trade and tourism. That defeats the purpose of leaving the euro – the sort of pointless compromise you expect from a British politician. Berlusconi now also wants to respect EU limits on deficits and debts. But his proposed fiscal policies don’t back this.

The Northern League and its cousin in the south, the Brothers of Italy party, hold just under 20% in the polls. They want to leave the euro and its deficit rules in a non-disruptive way. Good luck with that.

Despite recently making their policies far more moderate, keep in mind that the selection of new parties surged into the running largely by rejecting the euro. Just over a year ago, the leader of the party currently leading in the polls was calling for a default on Italian debt and a return to the lira. And the Northern League leader called the euro “a crime against humanity”.

They’ve since softened their stance. But the anti-euro sentiment is of course still there. In fact, Italians are among the most eurosceptic members of the EU.

But could Italy really cause trouble for the entire euro system?

The Italian election could sink the euro

There’s a particular reason the election in Italy is so important to the euro.

The political parties all have plans to worsen the government budget even more. This would violate EU rules, leading to a political standoff.

And so the Italians are holding a gun to their own head as a means to threaten the EU into approving their crazy schemes. If the EU doesn’t approve the Italian government’s plan to spend even more money, Italy will leave the euro or default.

One potential prime minister or economic minister is already talking about restructuring Italy’s debts. He knows the EU will “come to the table” to negotiate because the alternative is an exit from the euro – a political embarrassment that would make Brexit look rather clever – and a default.

Unfortunately, Deutsche Bank analysts recently wrote that even a negotiated restructuring “obviously leading to a financial crisis.” Not a surprise given the turbulence Greece caused with its restructuring.

The bluster of Italian politicians tells you they know the most important political fact of the eurozone. Italy is too big to fail and too big to save, but the EU is desperate to keep it inside the eurozone. Threatening self-harm is a viable strategy for Italian politicians to get what they want.

But what they want is not even a mildly credible fiscal plan. It will only worsen Italy’s financial situation, deferring the crash at best.

Once the market realises Italy is on a downward spiral with politicians who know they can get away with anything, Italian debt will be repriced. And with the ECB’s QE policy ending this year, there’ll be nobody to support Italian bonds.

This is the domino that ends the euro.

Until next time,

Nick Hubble
Capital & Conflict

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