If you have been a keen watcher of Europe and countries like France, Germany, Italy, Greece and Spain over the past decade, the news flow and fortunes of the region may by now bear a strong resemblance to the classic crime-comedy series Fargo. Every season, the series shifts to a new location in Midwest US, with an entirely new cast and period settings – yet with the same central dilemma at its heart about the absurd human motivations behind crime.
Since 2010, the Euro Crisis has followed a similar arc, shifting from one region to another – Greece (2010), Peripheral countries (2011), Greece 2.0 (2012), Cyprus (2013), EU (2014), Greece 3.0 (2015), UK (2016), France and Spain (2017), and Italy (2018) - with each episode posing the same fundamental questions about the stability of the EU as a unique institutional experiment in modern history.
It is not as if the European Commission and the Council leaders’ handling of the Euro crisis has been dismal. More often than not, grudging compromises were made at the last moment to avert a complete disaster. This often led to the creation of new institutions, or the expansion of the powers of existing ones that improved risk-sharing mechanisms and insulated the European Union from a market-orchestrated breakdown.
To prevent a sudden stop in capital flows to highly indebted PIIGS (Portugal, Ireland, Italy, Greece and Spain), the European Central Bank’s mandate was expanded to allow a Quantitative Easing programme centered around doing “whatever it takes” to preserve the single currency area. The other legacy of this era is the European Stability Mechanism, a permanent firewall with up to 700 billion euros in authorised capital to provide emergency bailouts.
However, such eleventh-hour measures to save the euro have come at a cost – and that is becoming more apparent as the Eurozone enters the fifth year of economic expansion. The price of a more fiscally and monetarily integrated Europe was first made apparent in late 2011. Democratically elected prime ministers of Greece and Italy were replaced at the behest of the Euro-Crisis troika (European Commission, ECB and IMF) by appointees who had been long-term bureaucrats and policy advisers at such intergovernmental bodies.
This was part of the conditionality imposed by creditor countries on Greece and Italy to provide immediate assistance to finance their fiscal deficits. As the Eurozone moved towards greater institutional integration with the creation of a banking union, a common deposit insurance facility, a consolidated budget that has a greater say in national spending and a common European defence force, the apparent transfer of agency from national governments to supranational bodies has become a rallying point even within the founding members of the Eurozone – notably Italy.
It would be wrong to blame administrative institutions at the EU level – the European Parliament and the European Council (EU Government) - for imposing the cost for greater economic and institutional integration on the citizens of Europe. Firstly, the disempowerment that national voters felt due to the progress of the EU project largely owes itself to the structure of the European Parliament. While in theory, EU is much like a voluntary confederation of states or “Staatenverbund”, the European Parliament does not allow equal representation to each state. Larger states like Germany and France have more MEPs and hence a greater say in region-wide policy-making relative to smaller ones like Estonia and Greece.
An ideal representative body for the European Parliament should have been similar to the US Senate, where each state has an equal number of seats - two - and is thus ensured an equal say in making policies and laws that impact the entire union.
Secondly, in theory, EU’s administrative bodies are expected to legislate on critical economic, judicial, foreign and social policy issues as a “community”, leaving behind partisan national interests.
However, at critical times and for crucial policy directives, the dominant members of the EU –Germany and France - have preferred to negotiate “inter-governmentally”, often choosing to override the decisions of the EU government on such matters. Therefore, perhaps as a compromise, the European Parliament and Council leaders have limited themselves to areas where they are unlikely to face a direct confrontation with the national governments.
This largely explains the reason why the EU government remains so insistent on fiscal deficit and debt limits, as enshrined in the Maastricht Treaty (which has the support of both France and Germany). On the other hand, the progress on the Competitiveness Pact, which could have given a bigger boost to the European Single Market by allowing for greater flexibility in labour movement and wage setting, has been delayed for over seven years mainly because France and Belgium consider the recommendations politically unpalatable.
Ergo, today the resentment is not about a bigger Europe, but about a Europe in which the citizens, particularly from smaller countries or regional minorities, have little say.
Given this prelude, what should we be watching out for in Europe next year?
Though Italy figured just once as the flashpoint of the Euro crisis, in essence, much of the response of Eurozone members towards resolving the sovereign debt crisis has been designed keeping an Italian default in mind.
Since the beginning of the EU, its third-largest economy has been the proverbial “sick man” of the region. Its economic growth has barely moved above 2 percent over the past three decades, and has remained under 1 percent since the end of the global financial crisis.
Income levels in Italy have remained stagnant at 1998 levels and the share of youth not in employment, education or training, at 26 percent in 2018, was even higher than that for Greece. The economy remains riddled with zombie firms, which take in resources and postpone a formal bankruptcy, inhibiting the rate of growth of startups. Among the OECD group of developed nations, Italy has the slowest rate of formation of new enterprises, and the pace has been steadily falling since 2008.
Yet, with $2.6 trillion in debt (almost the size of the Indian economy at market exchange rates), Italy is too big to bail out.
Its debt-to-GDP ratio currently stands at 131 percent, more than twice as high as the mandated 60 percent limit by the EU. These facts were not unknown to EU leaders when the crisis began in 2010. Indeed, one reason that the European Central Bank decided to engage in the Outright Monetary Transactions (or OMT) programme was to pre-emptively quell fears that yields on Italian bonds could spike if investors began to worry about EU’s inability to bail out Italy.
The desire to break the link between weak banks and weak governments, which was the most prominent in the case of Italy, pushed European governments to rush towards setting up a single banking regulator and agree to some form of deposit insurance to save small retail depositors in case the banks failed.
However, all these institutions were simply stop-gap arrangements, meant to simply delay the core problem of the Italian economy – the lack of productivity.
Measures to reduce labour market rigidities, increase public and private investment in R&D, tackle corruption and tax avoidance and downsize an ineffective bureaucracy never found strong political support. Kicking reforms down the road has now led to a situation where Italian debt to GDP ratio looks set to further increase, unless someone – EU governments, private bondholders or Italian citizens - take the pain.
The Italian government currently looks set for a showdown with the EU over its proposed budget for 2019, which sees the fiscal deficit balloon from 1.8 percent of the GDP to 2.4 percent. Some of the highlights of this budget were cuts in corporate income taxes, postponement of a value-added tax and bringing back the maximum retirement age from 62 to 60. Added to that is also a proposal for a citizen’s income, a variant of universal basic income, which has been a key plank of the 5 Star Movement, the dominant partner in the ruling coalition.
Ordinarily, a 2.4 percent fiscal deficit should not raise eyebrows for any EU country given that it is well below the 3 percent limit mandated by the Maastricht treaty. However, as a highly indebted nation, Italy is under the EU’s surveillance and is therefore required to cut its fiscal deficit to zero in order to stabilize its debt.
Latest reports suggest the Italian government agreed to back down on its fiscal deficit target under pressure from the EU, agreeing to keep its deficit limited to 2 percent of GDP. Even so, risk that the actual fiscal deficit in 2019 will exceed the government’s estimates are pretty high given that the government expects the proposed mix of tax cuts and spending plans to push up GDP growth to 1.5 percent next year, a pace not seen by the economy in a decade.
What happens in Italy should have everyone in the global markets worried. Despite the efforts undertaken by EU to break the link between indebted governments and domestic banks with poor assets, Italy’s banks still remain highly exposed to the domestic government debt, relative to other European peers.
As per research by Citibank, a 1 percent increase in the yield spread between Italian and German bonds would wipe out the Tier 1 Equity Capital of banks in the country by 0.35-0.7 percent. It is to be noted that this spread was about 6 percent at the height of the Euro crisis in 2011, which would have implied a near collapse of some state-owned banks in Italy, had the ECB and EU not stepped in.
Repeating that same miracle will be difficult – Italy’s debts are larger, and the EU is already saddled with the bailouts for Greece and Cyprus.
To compound the troubles, a spike in local bond yields will increase the funding costs for Italian banks, and they would have to pass it on to households through higher mortgage rates – further squeezing an already stagnating economy. Moreover, in case a bank goes under, the EU is unlikely to fully bail out Italian lenders to the bank and would demand some participation from local depositors. Given that Italian retail depositors have already bailed out two local banks in 2016, it would be too much to ask them for another participation without risking the stability of the government.
As of now, a spike in local bond yields and fear of sanctions by the European Commission have again pushed Italian politicians and public to agree to compromises necessary in order to stay in the Eurozone.
However, the question is, without the essential reforms, Italy’s debt numbers will simply be a symptom of its underlying productivity illness. What is more worrying is the way in which the necessity of fiscal discipline is communicated by Italian politicians to the general public – as an external constraint required to stay in the Euro, rather than a necessity to resolve the issues that have made its economy less competitive and its standards of living practically stagnant.
This is important because the problems that Italy has with its competitiveness may not be fully resolved even if it breaks out of the Eurozone and manages to adopt an extremely devalued Lira. For one, we wonder how Italian exports, with higher unit labour costs, will compete in global markets. China, for example, has an immense logistical and technological edge, aside from having lower wages. Furthermore, under-investment in infrastructure and high barriers to starting up will continue to bedevil the economy, whether one remains within or outside the Eurozone.
The institutional inconsistency at the heart of the EU, where policy decisions are made by a government that is perceived to not be representative, have much to blame for this predicament. In Italy or elsewhere, even if difficult compromises are made, they will most likely be resented by the voters as directives to have come from foreign governments.
My guess is that next year will be another episode in the Euro drama - with Italy almost threatening to quit the EU, but never quite having the courage to do it.
Even so, we should still see a progressive radicalisation of politics in the single currency area with parties that sell the fantasy of a break from the Eurozone finding an increasing number of supporters.