As Nobel laureate Joseph Stiglitz has observed, the common currency project is responsible for exacerbating an increasingly dysfunctional marriage, which has failed to deliver what was promised at the time that the marriage vows were taken: “[the] two principal goals of prosperity and political integration: these goals are now more distant than they were before the creation of the eurozone.”
Unfortunately, we are quickly approaching the point in which Italy seizes up the courage to get up and leave the marriage. Italy, however, is not Greece, but a significant economic power in its own right. Were this divorce to happen, therefore, it would create a tremendous financial fallout for the rest of us, and likely mean the end of the euro itself.
Italy’s economy continues to be mired in stagnation or worse. As Thomas Fazi has described it:
“Since the financial crisis of 2007–9, Italy’s GDP has shrunk by a massive 10 percent, regressing to levels last seen over a decade ago. In terms of per capita GDP, the situation is even more shocking: according to this measure, Italy has regressed back to levels of twenty years ago, before the country became a founding member of the single currency. Italy and Greece are the only industrialized countries that have yet to see economic activity surpass pre–financial crisis levels. As a result, around 20 percent of Italy’s industrial capacity has been destroyed, and 30 percent of the country’s firms have defaulted.”
The Italian banking system has also come under considerable strain, the country’s credit rating has been downgraded again, and its funding costs continue to rise, as the European Central Bank (ECB) winds up its own program of quantitative easing. Although funding costs are not germane in a country that issues its own currency (e.g., the U.S., Canada, Japan, etc.), they are highly relevant in the eurozone, where the countries are users of the currency, therefore functionally akin to an American state or Canadian province and, hence, subject to vagaries of market-determined rates, and the actions of the unelected bureaucrats who run the ECB. As such, these “states” are subject to solvency risk, as they themselves cannot create the euros to fund their debt.
This is not a bug, but a feature of the eurozone. It was part of a Berlin-backed effort to control “fiscal profligates,” such as Italy, while simultaneously foreclosing to Rome the option of a currency devaluation (which, by happy coincidence, has ensured Germany’s ongoing global export dominance, as its massive current account surplus illustrates). Competitiveness can only be restored, therefore, via an “internal devaluation,” which essentially means crushing the living standards of the Italian people, so that they can compete in the global export market, rather than using fiscal policy to enhance the country’s domestic economy.
Understandably, the current coalition government in Rome doesn’t want to play along. They were elected to defend the interests of the Italian people and deliver a different sort of economic program, which doesn’t consign the electorate to another decade of declining living standards. And Italy’s voters remain supportive, if the most recent polls are anything to go by. Hence, the coalition’s resistance to Brussels/Berlin–imposed spending limits.
The solvency issue within the eurozone was essentially resolved after ECB President Mario Draghi’s “whatever it takes to preserve the euro” speech, because as the sole issuer of the euro, Europe’s central bank was (and is) the only institution that could credibly backstop the debt without limit. The ECB is now starting to wind down its bond-buying program. But even if the ECB were to continue backstopping the national debts of the EZ members without limit, the additional problem of demand-deficient economies has not gone away, because a robust fiscal response is also circumscribed via the so-called “Stability and Growth Pact” (SGP). The SGP restricts budget deficit to only 3 percent of GDP and overall public debt to 60 percent of GDP. Even though virtually every country within the eurozone, including fiscally virtuous Germany, has routinely breached these limits, these rules do matter because, under Maastricht Treaty terms, countries can be punished by European institutions and also by markets, as has occurred to Greece and now is increasingly happening to Italy.
Greece was small enough that its problems could easily be cauterized by the rest of the EU, even if it had left the eurozone, but Italy is truly “too big to fail.” It’s the world’s 10th-largest economy. The problem is that for Italy to secure additional fiscal leeway to revive domestic demand, it needs to preserve the ultimate “nuclear option” threat of withdrawing from the EZ if Brussels proves unyielding. That could prove economically calamitous, exposing the country’s international creditors (including other eurozone nations, such as Germany and France) to literally trillions in liabilities. To be repaid in what? Euros? A reconstituted, and possibly heavily devalued, lira? What happens to the pension funds? What about capital flight? Runs on the banks? The point is that Italy does have leverage, but deploying the leverage will be costly for all concerned.
Which explains why, even though the new right-wing populist coalition in Rome has many viscerally anti-euro Cabinet members, the government is playing a double-game. It continues to push for more fiscal leeway, resisting threats of fines and sanctions, while simultaneously pledging to stay in the monetary union. Since this showdown is coming at a time when Mario Draghi has already started to reduce the ECB’s bond-buying program, the Italian government’s plans have been compromised by the market’s adverse reaction, evidenced by the more than doubling of Italian bond yields to 3.5 percent (from a low of 1.633 percent), and more significantly, a widening of the spread between Italian and German 10-year bond yields to over 300 basis points (this spread is considered to be the best barometer of financial stress). A recent study by Credit Suisse calculates that if credit spreads between Italian and German 10-year debt widen to more than 400 basis points, it could take down a number of leading Italian banks, as their capital buffers would be eviscerated. Already, as John Authers notes:
“The spread is currently the widest since early 2013… wider than it was after the bailouts of Greece, Ireland and Portugal. It’s also the equivalent to the level reached in late August 2011, only a matter of weeks before it peaked and forced Prime Minister Silvio Berlusconi to resign.”
So we have an interesting, but risky, game of chicken developing. Brussels has now rejected Italy’s proposed new budget, and Rome has refused to back down, putting the markets in turmoil.
In this dispute, the Italians are right. If anything, even the government’s proposed new spending measures are inadequate relative to the degree of unemployment now pertaining in Italy (currently around 10.6 percent). In fact, netting out interest payments to its creditors, Italy in fact is running a primary budget surplus, which, if sustained, will (in the words of Italian economist Orsola Costantini): “lock... the country into stagnation and expose... its banking system to still more stress. With public investments at historically low levels, unemployment still above the 2008 rate in all regions, and a youth unemployment rate above 30%, it is hard not to see a strong case for fiscal stimulus.”
Economic forecasting is a mug’s game, because one can never judge “ex post” outcomes in advance of assessing the actual impact of spending decisions taken “ex ante.” In other words, if experience of the European Union’s austerity bias has illustrated anything, it is that, paradoxically, attempts to proactively cut government spending in the face of declining economic conditions actually exacerbate deficits, rather than diminish them.
And the notion that Italy’s high unemployment is a function of “structural rigidities in the labor market” (i.e., code for allowing companies to make it easier to fire their workers) is bogus. After all, Spain introduced “structural market reforms” under the policy recommendations of the EU’s technocratic elites in 2004, when it had a structural unemployment rate of 10.4 percent. By 2015, under ostensibly more flexible labor market conditions, the Spanish unemployment rate had exploded to over 21 percent (after being as high as 26 percent in 2013). Even today, with its supposedly flexible labor markets, Spanish unemployment is over 15 percent.
Yes, Spain suffered from a major banking crisis, which caused public debt to explode as the private debts were assumed by the government and the economy collapsed. But the huge demand deficiency in the economy remained largely unaddressed because successive governments failed to produce an adequate fiscal policy response, flexible labor markets be damned. In this, Madrid was “encouraged” by the EU, and in a curious case of Stockholm syndrome (or, in this case, “Berlin syndrome”) went along (although that country, too, is beginning to experience resultant strains in its own federation as a result).
What the Spanish experience does illustrate is that supply-side reforms, such as labor market liberalization, in and of themselves, do nothing to mitigate unemployment in the absence of a robust fiscal policy response (i.e., more spending or tax cuts). There is no reason to think that the experience in “fiscally profligate” Italy would be any different were Rome to accept the policy recommendations of the European Commission.
It’s worth pondering the real reasons why the EU’s policy elites continue to advocate for a policy that has been such a consistent failure. The answer is clearly a political one, which I have addressed before: “Industrial Germany rightly perceived that a broadly based eurozone, which incorporated chronic currency devaluers such as Italy, permanently entrenched their competitive advantage. And with the support of this key component of German society, Chancellor Kohl was able to embark on the huge institutional transformation embodied in the Maastricht Treaty,” notwithstanding the opposition of the Bundesbank (which was partly mollified by the Bundesbank-like powers given to the new European Central Bank in the Treaty).
The current austerity overreach mindlessly advocated in Berlin and by its lieutenants in Brussels is inevitably creating the conditions for a future crisis in the European Union—inevitable because the EU has been designed in such a way as to subjugate the democratic aspirations of its member states in favor of capital. That can only go on for so long in a continent historically dominated by wars, upheaval, and revolution. Especially in Italy, which is among the least stable polities in the European Union. Given the recent history of the EU, the most likely response to the current crisis is another stop-gap measure, deferring the broader problem until later. In the short term, this will sustain an existing structure that largely serves the interests of German industrialists, but not the people of Europe as a whole. Barring a wholesale shift in ideology, therefore, any short-term stitch-up will just set the stage for a bigger problem down the road, likely provoking more nationalist backlash against the EU, which continues to play with fire, backed by Berlin. Germany may therefore end up with total dominance over something that doesn’t work, and holding the creditor bag on a currency that eventually may not exist.
This article was produced by the Independent Media Institute.
