Return of the lira

Nick Hubble

The lira is coming back. After two months of silence from Italy’s coalition negotiations, it’s all happening too fast.

Remember, politics is Italy’s only way out of the euro. That currency and its monetary policy has kept one of the world’s major economies in the doldrums since its inception. GDP has barely grown since Italy joined. There have been five recessions in that time.

But the people are fighting back. Three eurosceptic political parties rose to prominence by rejecting the euro and the EU’s rules. They’ve since softened their stance on Europe to just rejecting the EU’s budget rules. But the anti-euro sentiment is still in the electorate.

Yesterday evening the Five Star Movement and Lega struck a deal to form a government together. The consequences for the EU, the euro and debt markets couldn’t be bigger.

If you want to be prepared for the coming crisis, keeping an eye on Italian politics is crucial. I’ll try and make a confusing mess coherent for you…

Italy’s new government

The compromise set of policies between the far-left and centre-right are full of dramatic changes to the status quo. The new government will likely launch its own parallel currency to compete with the euro, completely trash what’s left of Italy’s fiscal ruins, and become a major pain in the neck for the EU. That’s the summary, anyway.

This is very much in line with my prediction about what’ll happen to Europe in coming months.

One stepping stone towards the crisis was provided by the former Italian leader Silvio Berlusconi. He gave his endorsement for the other two major parties to form government last week.

These are the left-wing Five Star Movement and the fairly far right-wing Lega. They were at the negotiating table until last night, when they announced a deal.

The left/right mantra is proven false by the fact that these two parties could form a coherent set of policies. In truth, they are merely promising dramatic change. There isn’t much traditional coherence in their positions. It’s a real hodgepodge of ideas. Some of them I even like.

Berlusconi’s endorsement was crucial because his party had expected to form government with Lega in a coalition deal made before the election. But they didn’t get enough votes, even together. Lega more or less needed Berlusconi’s permission to leave the alliance and join up with Five Star.

The new coalition between Five Star and Lega is expected to throw up an odd set of policies:

  • The prime minister will be a neutral arbitrator between the leaders of the two parties. Probably a career diplomat.
  • Pension reforms will be stopped, putting Italy back on to a disastrous fiscal path instead of just a bad one.
  • A flat tax on companies and people will mean a huge tax cut costing tens of billions of euros a year.
  • A type of universal income will launch to ensure minimum living standards.
  • EU fiscal rules will be renegotiated to allow Italy to stimulate its economy with deficit spending.
  • Immigration cuts.
  • Pushing for a pro-Russia agenda in the EU.
  • And, most importantly, the country will explore launching a parallel currency.

Most of those policies only worsen Italy’s fiscal decline. Some are all about sticking it to the EU. Italians see the immigration debacle as Angela Merkel’s fault for her open-door policy. Now they’ve had their say by giving Merkel a rock in her boot.

But it’s the parallel currency that’s the key. This is essentially the first step to leaving the euro. It’s still well disguised. But that’s what it is.

I’ll explain what the Italians have planned for their money in a moment. First, realise what it’ll mean.

If the Italians pull this off successfully, there’ll be no reason to keep the euro. And other nations will follow Italy.

If a big chunk of the eurozone isn’t using the euro, it’s defunct.

And a defunct currency is worthless. Which will make debt markets denominated in euro panic.

Introducing the mini-BOT

Of all the financial frauds committed by government, the mini-BOT is not a particularly pernicious one. The trouble is, it doesn’t really solve the problem. In fact, it doesn’t do much at all except forestall a reckoning.

Which is why I think the real purpose of the new currency is to prepare Italy for a return to the lira. As Reuters put it, “Italy’s dual currency schemes may be long road to euro exit”. Back to that in a moment.

The so-called mini-BOT parallel currency system was also considered in Greece by upstart finance minister Yanis Varoufakis. But the European Central Bank wasn’t a fan. For the reason I just mentioned.

Here’s how it works…

The mini-BOT is a “fiscal currency”. A tradeable tax credit.

It can be used to pay your taxes. And it can be used by the government to pay its bills from the private sector. It can’t be exchanged for euros, and there are limits to how it can be exchanged between companies and people.

The intended effect is to stop the outflow of euros from government coffers, reducing borrowing needs. The increased amount of “money” would also grease the wheels of commerce.

But in reality, the mini-BOT is just a new debt incurred by government – a form of borrowing that is compulsory for the government’s partners in the private sector.

Here’s how it works in practice. First the Italian government pays its bills from the private sector in freshly created mini-BOTs instead of euros. Then, in the future, the mini-BOTs can be paid to the government instead of euros when taxes are due.

What’s the effect? The Italian government doesn’t have to pay in euros, it can pay in mini-BOTs it creates – effectively a tax credit.

But by paying the private sector with a form of tax credit, Italy’s government is going to forgo tax revenue when those tax credits are eventually redeemed. The government will receive nothing but its arbitrary currency back instead of euros when taxes are due.

When it comes down to it, the mini-BOT is a bit melodramatic in terms of the effect it’ll actually have on Italy’s finances. Right now, the government owes vast amounts of euros to private companies. Euros it doesn’t have, and can’t borrow under EU deficit rules.

By “paying” bills in mini-NOTs instead of euro, the government gets to keep those euros. But when those companies have to pay taxes, they’ll just pay in mini-BOTs, depriving the Italian government of the tax revenue it’ll so desperately need in the future.

The net effect of the mini-BOT is to buy time. That’s why it’s like a debt.

One plan is for the mini-BOTs to last two years before being redeemed. That’d make they’re like a two-year government bond.

But the parallel currency does have one redeeming factor. Mini-BOT debt – in the form of lost future tax revenue – is not counted as official debt in government accounts. The mini-BOT allows the Italian government to borrow money in such an obscure way that it isn’t counted as debt by statistics.

It’s an accounting fraud.

The real solution

The underlying problem Italy faces is that it cannot issue its own euros. So the government can’t print its way out of debt by devaluing the currency. If it left the euro it could though…

Lega wants to leave the euro eventually, but cautiously. Five Star has abandoned the pledge for a referendum on the euro. Despite this, it is the inevitable endgame for Italy.

And that’s when even pound sterling using Brexit Britain will be in trouble.

Until next time,

Nick Hubble
Capital & Conflict

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Category: Geopolitics

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