Why the Italian crisis won’t see Italy leave the euro just yet

Note: This post was first published on Patreon on 31 May 2018

Italy’s not going anywhere. And that’s because the eurosceptic parties trying to form a government from a majority in the last general election don’t have a mandate to leave the euro. They won’t get one anytime soon either. That’s the headline here. Here are the details.

Now, I think this crisis has legs. But, for now, the panic has subsided. And that’s because markets are beginning to realize that reasonable worst case scenarios don’t involve an Italian exit from the euro. Polls have consistently shown that Italians, despite their support for eurosceptic parties, don’t want to give up the euro. They just want more control, more sovereignty.

Look at the latest polls. They show 60 to 72% of Italians in favour of remaining in the eurozone with only 23 to 24% in favour of leaving. That’s a solid majority, with 3 times as many Italians wanting to keep the euro as those who want to go back to the lira.

There is no political mandate to leave the euro. There is unlikely to be one anytime soon. And if the next election is held as a referndum to leave, the parties making that wish explicit will be trounced.

We’ve seen this before. In Greece, Syriza was never saying it wanted to leave the eurozone. How could it? Public opinion in Greece, as in Italy, has been consistently in favour of remaining in the eurozone. The party merely wanted to assert more sovereignty over its fiscal options because of the severity of the post-financial crisis downturn. In that case, voters backed this assertion of fiscal sovereignty. But Syriza was thwarted as the ECB pulled the plug and forced the Greeks to toe the line.

So what we’re seeing in Italy is not the precursor to a calamitous exit from the eurozone, but rather a power struggle over the economics of fiscal expansion and over how tightly to administer the stability and growth pact. The mandate the Lega-Five Star coalition had, if any, is to relieve pressure on the Italian economy by loosening the fiscal taps.

The appointment of Paolo Savona, who has supported so-called secret plans to leave the eurozone prompted the President to reject the coalition government, throwing the country into an alleged constitutional crisis. But were the eurosceptic parties to decide on someone less radioactive, they could form a government. Italian President Sergio Mattarella has said so, according to Reuters:

Luigi Di Maio, head of the 5-Star Movement which emerged from inconclusive elections in March as the biggest party in parliament, appealed to the League to drop its insistence on Savona as economy minister, so that the two parties could resurrect their bid to govern together.

“Let’s find someone of the same caliber as Savona, who would still remain in the government in another ministry,” Di Maio said on Facebook after meeting with Mattarella.

Mattarella welcomed the proposal, according to his staff. League leader Matteo Salvini, who is surging in opinion polls, seemed cool on the idea but did not rule it out.

“I hope we can launch a government, we’ll see in the coming hours,” he told party supporters.

Where do we go from here then?

I think we will see the eurosceptic coalition try and put someone less controversial into the finance ministry. And if they do, they may well form a government. Nevertheless, their ideas about more fiscal leeway won’t get very far. Despite Italy’s having had a primary surplus for years, there is no appetite in Brussels or Berlin for relaxing the rules. In fact, in German circles the commonly held belief is that relaxing the rules for Jacques Chirac’s France and Gerhard Schroeder’s Germany is what created the European sovereign debt crisis in the first place. The Germans believe that a stricter adherence to the rules will prevent any crisis in the future.

My view is that Italy remains a weak link economically. The legacy pre-euro deficits are an albatross around the economy’s neck because it restricts the amount of fiscal freedom Italy has to deal with its aging and slow-growing economy. If and when we see a recession, Italy will be in a world of hurt. This is just a precursor to that.

In the meantime, wait for a governing coalition to form and for it to directly demand fiscal stimulus in contravention of the stability and growth pact. If we do get a eurosceptic government that calls for flouting the stability and growth pact rules, expect the ratings agencies to downgrade Italian debt and for another panic to ensue as investors flee Italian bonds.

At some point, the ECB will likely be called into action. And they will give Italy an ultimatum on the fiscal front, just as they did with Greece. That’s when the fireworks will really begin. We’re not there yet.