Italy’s Political Crisis Is a European Union Crisis

Do leopards change their spots? Because that’s really the question everybody has to ask, now that Italy’s president, Sergio Mattarella, has finally approved a new Italian government. The new coalition represents an odd mixture of euro-skeptical technocrats and populist xenophobes from two anti-establishment parties, Five Star Movement and the League, who finally cobbled together a mutually acceptable Cabinet that secured presidential approval (earlier vetoed). Can the Brussels elites, who increasingly call the shots in Europe, live with this new government, or will their ongoing insistence on the austerity-biased policy status quo cause the new coalition to fall apart?

If the latter, it will almost certainly lead to a new, more radical political configuration that could amount to a referendum on Italy’s continued membership in the monetary union. This has hitherto been a taboo subject for most Italians and was never explicitly addressed in the last election even by the two leading parties who largely comprise the new Parliamentary majority. But lurking in the background is “Brothers of Italy,” a descendant of the post-fascist Italian Social Movement (MSI), which is even more viscerally anti-euro.

Why has the euro itself become such a political flashpoint? Largely because Italy’s decision to join the European Monetary Union (EMU) is inextricably tied up with the question of national sovereignty. From the time Italy joined the single currency, it became a user, rather than issuer, of the currency. That means that much like a state government in, say, the United States or a Canadian province, euro zone countries use a currency that they don’t control (they can’t set interest rates nor can they roll over the debt with newly issued money and thus, unlike countries that issue debt in their own currency, they are subject to risk of default). Borrowing in a “foreign currency” means the Italian government is constrained in its ability to provide high levels of employment and output via fiscal policy, which has meant years of economic stagnation, high unemployment (especially in the south), and the gradual deindustrialization of the country. This has led many (including members of the new government) to call for an Italian exit from the single currency union. But an “Italexit” from the euro zone would pose existential challenges to the very existence of the single currency project and indeed, to the European Union itself in a way that dwarfs either Greece or Brexit.

It is true that the EU has survived many crises before—Brexit, Greece, Ireland, Spain/Catalonia—and this has often been achieved through the simple expedient of having its elites ride roughshod over voter preferences, election or referendum results be damned. In many cases, it is these crises that have consolidated and strengthened the EU body and its bureaucracies.

But in the era of Donald Trump, many hitherto taboo political lines have been erased by the forces of populism. Hence, one should not readily assume that Italy’s new anti-establishment government will quiescently fall in line to Brussels’ bullying elites, as, say, Athens has done.

Nor is the UK situation particularly relevant here. With the retention of its own currency, Britain has always maintained a “half in, half out” relationship with the euro zone countries, which makes Brexit less problematic in terms of securing a divorce, which minimizes systemic damage to the euro or the broader political contours of the EU. So the EU can afford to take a hard line in its negotiations with the UK.

Italy is the EU’s third-largest economy, and a founding member of the European Economic Community as well as an original member of the euro zone. So the tough approach used for Britain would be counterproductive in the case of Italy. Were an “Italexit” to occur, it would represent a profound political failure, a possibly irreparable wound for the EU. Seventy years of integration in Europe is an immense, highly stable counterforce to the blood-soaked history of the European continent. But that could all be swept away if Brussels power brokers remain adamant that there is no alternative to the prevailing economic status quo, and persist in characterizing the new government as “the scroungers from Rome.”

That is playing fire with the new Italian administration, whose nationalism is being kept under wraps via the presence of a few face-saving apolitical technocrats in the new Cabinet, including the prime minister himself. But the prime minister, Giuseppe Conte, is a figurehead. Much like the duke of Portland in Britain’s Fox-North coalition government of 1783 (the duke only nominally in charge, with real power in the hands of Fox and North), Conte’s main role is to serve as interlocutor between the coalition’s two party leaders, both of whom have pledged have pledged to keep the country within the euro, for the time being.

As for the party leaders themselves, the head of Five Star, Luigi di Maio, was on record as recently as last December stating that Italy needed to leave the euro in a very explicit and direct manner (see here). Matteo Salvini of the League makes Donald Trump seem moderate by comparison on the question of immigration, advocating the expulsion of 500,000 suspected illegal immigrants from Italy. The new minister for the EU (originally proposed as finance minister, but rejected), Paolo Savona, is part of a network of euro-skeptical economists who advocate “a controlled segmentation of the Eurozone.” He has also called the euro a “German cage.” Although not finance minister (he was vetoed by the president), Savona remains a powerful deputy minister, an intellectual godfather much like Steve Bannon was earlier for President Trump.

It is also worth noting that the two main governing parties are not the most radical in Italy. Even more explicitly euro-skeptical is the “Brothers of Italy” Party, the main heir to Italy’s longstanding fascist tradition. If the coalition tries to deliver a tax cut which is rejected by Brussels, the League leader, Salvini, could well take his party out of the government, force new elections, match up with Giorgia Meloni, leader of the Brothers, and quite possibly overtake Five Star at the next elections. Those are political realities to which the EU’s technocratic elites must pay heed before they contemplate Troika-style heavy-handedness in Italy, as they did in Greece.

Unfortunately, the early signs are not promising. Even in the midst of delicate political negotiations and corresponding bond market turmoil, EU budget commissioner Gunther Oettinger urged Italy’s president “not to hand power to populists on the right and left…. The markets will teach Italy to vote for the right thing,” provoking such an intense domestic reaction that ultimately forced Donald Tusk, president of the European Council, to cool things down, tweeting: “My appeal to all EU institutions: please respect the voters. We are there to serve them, not to lecture them.”

So what should be the response of Brussels and, equally important, Berlin? Sometimes, you need to give a little to get a little. In the case of the U.S., for example, President Franklin Delano Roosevelt remarked: “People who are hungry and out of a job are the stuff of which dictatorships are made.” It was precisely this kind of political calculation that led FDR and Congress to create the New Deal, which in turn likely saved the republic. FDR faced political pressure that led him to recognized that a larger chunk of the economic pie had to be allocated to the casualties of the Great Depression in order to avert a more serious threat to the larger economic order.

Market considerations did not come into play; indeed, FDR flouted them when he took the U.S. off the gold standard. That action was contrary to all of the prevailing economic conventional wisdom, but the American president’s political calculus worked. The New Deal alleviated the gravest of the social strains brought about by the deflation of the 1930s, while preventing a descent into dictatorship. That’s the kind of good example that Brussels, the Italian president, Mario Draghi (president of the European Central Bank), and indeed, the international investor class all might want to recall.

What’s the worst that could happen in the event of a miscalculation? Consider the extreme case of Zimbabwe: when Robert Mugabe first came to power in 1980, the basis of the post-civil war settlement empowered the Zimbabwean authorities to initiate land redistribution. So long as land was bought and sold on a willing basis, the British government agreed to finance half the cost.

It was suggested to the white farmers (250,000 of whom owned virtually all of the arable land in a country of 6 million people) that giving up a portion of their land to black farmers would constitute a good foundation on which to build a more equitable economy, while minimizing the racial and tribal tensions brought about by decades of civil war. 

Much like today’s inflexible “austerians,” the white farmers didn’t give much ground, selling less than half of the government’s intended target for black resettlement, affecting a mere 50,000 households. That was costly: the failure to recognize Zimbabwe’s new political realities ultimately created the conditions for a much more extreme political upheaval and land expropriation 20 years later, where the white farmers lost everything.

To be sure, Italy is neither America in the Great Depression, nor Mugabe’s Zimbabwe. But Italian unemployment has remained stuck in double digits for years in spite of the fact that the country currently runs a trade surplus. Exports therefore are not doing enough to cut unemployment, which suggests that more public spending is required to reduce it. Although much has been made of the coalition’s anti-immigration policy (featuring a promise to build more detention centers and use the armed forces to deport 500,000 suspected illegal immigrants), their respective party policy planks offered a break from the fiscal status quo as well, according to the Bruegel Institute:

“M5S and League’s electoral promises… both centered on a more expansionary fiscal stance, although with major differences. M5S promised the introduction of a minimum guaranteed income—which appealed to voters in the economically suffering south. The League party promised a flat tax—which appealed to voters in the economically thriving north. Both parties advocated the repeal of a controversial pension reform introduced in 2011 by the government of former prime minister Mario Monti…. [and] have committed to repeal an otherwise automatic hike in the value-added tax (VAT) planned in the 2018 budget.”

The coalition also wants to introduce a two-tier income-tax system, with rates of 15 percent and 20 percent making Italy one of the lowest-taxed countries in the EU. 

In aggregate, this fiscal largesse represents an increasing of net public spending of close to 7 percent of GDP into the Italian economy, a significant reflationary boost, but not unreasonable, given the fact that since 2008, Italy’s GDP has declined by 10 percent, lost 3 major banks, and experienced persistent double-digit unemployment (35 percent youth unemployment). The economic issue is that the spending must be large enough to enable the economy to grow (too small, and it could well discredit the future use of fiscal policy as being ineffective). The political problem is that there is no way this government can make it as large as it has promised and still remain compliant with the stringent EU fiscal rules. Something will have to give between Italy and the EU establishment, which retains a monomaniacal focus on structural reforms (particularly in the labor markets), arbitrary fiscal rules and “debt sustainability.”

Ironically, the nightmare scenario for Brussels is not Italy’s failure, but that the fiscal boost works too well to revive Italy’s domestic demand. That would not only boost the coalition’s popularity in Italy, but discredit the prevailing austerity bias now dominant within the EU (another good reason why Brussels’ mandarins would do well not to invest too much politically in the failing economic playbook that it adopted with Greece).

What is conveniently ignored when opinion leaders discuss Italy’s “unsustainable” public debt (now around 132 percent of GDP) and supposed “labor market inefficiencies” is that these “problems” did not prevent the Italian economy from growing robustly in the pre-euro era. Why? Because when Italy had its own currency, it had full fiscal flexibility (along with the ability to devalue). It wasn’t borrowing in a foreign currency, which leaves it at the mercy of the markets.

No question today it would be tough to exit the euro zone without significant economic disruption, to say nothing of the formidable IT hurdles required to re-introduce the lira seamlessly. The electorate’s reticence to embrace “Italexit” also needs to be understood in the context of the other things Italy gained since joining the euro: access to the common market, protections for its agriculture and industries, the efficiencies of coalition bargaining with non-EU countries on trade issues, massive subsidies and grants for development, and much more. But even with all of these benefits, let’s not pretend that membership in the single currency union has somehow fulfilled the promise of making Italy a wealthier country. Absent some degree of fiscal flexibility, the Italian economy will continue to endure, in the words of Professor Luigi Zingales, “a form of economic waterboarding that has left the Italian economy devastated and Italian voters legitimately angry at the European institutions.”

Much as one could argue that the Trump presidency represented a political reaction against an untenable status quo, so too have decades of economic stagnation engendered a profound political reaction in Italy against the establishment parties, who embraced Brussels’ market fundamentalism with the fervor of the convert. Taking their cue from Germany, their gambit was to restore Italy’s economic competitiveness via “internal devaluations”—which is what we have earlier characterized as an infernal devaluation. “It amounts to a domestic income deflation—as wages are crushed—in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth.”

Sure, it appears to have worked for Germany, but at the cost of introducing labor market “reforms” that have institutionalized poverty-level wages in that country, which have enabled Berlin to achieve persistently massive trade surpluses, in effect “stealing” growth from the rest of the euro zone countries. But Germany had “first mover advantage,” something not available to Italy. Indeed, in one of his few published statements on the euro zone, newly designated Finance Minister Giovanni Tria suggested that Germany’s relentless pursuit of trade surpluses has caused as much, if not more, instability and damage to the European Union, as the deficits of periphery countries such as Italy. If nothing else, it is the “profligacy” of Italy’s consumers that has facilitated Germany’s burgeoning trade surpluses, the export growth of the latter sufficiently robust to ensure that Germany’s government could produce balanced budgets (and lecture the rest of the EU about its fiscal virtues in the process).

Part of the appeal of Italy’s two anti-establishment parties was their promise to shake up the status quo. Sometimes things are so desperately in need of being shaken loose, that it matters less who does the shaking. And let us not be shy of the word “instability.” Stability should be a means to an end. However, when stability becomes as an end itself the result is paralysis, a very unhealthy development in a region characterized by ineffective policy making, which threatens the very existence of the values and institutions which the EU elites claim to hold dear.

Earlier in this article I mentioned FDR’s New Deal and Robert Mugabe’s land expropriation in Zimbabwe. They represent the binary outcomes. There is another recent historical example which may offer a middle way. During the first post-Suharto years in Indonesia during the 1990s, when various provinces were fighting for autonomy, it was paradoxically found that for the country to stay together it was deemed necessary for the Indonesia republic to come partially apart. That’s a good model for Brussels to heed. Neither the EU nor the euro can work optimally without deep political as well as economic integration and both went for quick monetary enlargement, minus an accompanying fiscal component. Unfortunately given today’s economic strains and growing political dysfunction, moves to address that faulty construction via a “United States of Europe” fiscal integration is impossible. In fact, continuing “full speed ahead” to this destination, however laudable the motives behind it, would make things worse. Consider the recent example of Yugoslavia, where the wealthier regions, Slovenia and Croatia, long resented policies that transferred of wealth to the relatively poorer republics, like Serbia, Macedonia, Montenegro, or the autonomous region of Kosovo. Once Tito’s organizing genius disappeared, the linkages stitching the country together became frayed and eventually snapped as old grievances manifested themselves in the form of a nasty civil war. This kind of resentment is already mounting in Germany and could well extend elsewhere. Mere financial engineering can’t overcome that.

Hence, a bit more fiscal space, less integration, more “multi-speed Europe” will have to do. Maybe even better: a “multi-tiered Europe,” given that many of Europe’s members don’t share the aspiration to arrive at the same political station of a fully united Europe at the end of the journey. The goal should to make the EU a sustainable, evolving organism, not simply a catechism of fiscal fundamentalism, irrelevant and insensitive to the economic and social needs of its members. To make it a sustainable entity means directing a more of the EU’s fiscal pie toward economic development, not perpetual bank bailouts. This redirection of fiscal resources can take the form of a pan-European investment in public infrastructure via Europe’s public investment banks (such as the European Investment Bank, whose existence is already enshrined and authorized in the Maastricht Treaty), or a Job Guarantee scheme to provide living-wage jobs in the public and non-profit sectors for every European in their home country, available on demand for all who want them and funded via the European Central Bank (the only credible funder, given its role as the issuer of the euro). Specifics aside, the broader point is that the monetary union and much else of today’s Europe are doomed absent an overhaul of the EU’s political machinery and a rethinking of its austerian theology.

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