Italy’s quadruple threat to Europe

STANFORD — Italy’s new minister of economy and finance, Giovanni Tria, has sought to reassure financial markets that the new Five Star Movement/League coalition government will neither abandon the euro nor blow up the budget deficit in violation of EU fiscal rules. But Europe is not out of the woods. Italy’s populist, euroskeptic government has further heightened the medium-term risks posed by the country’s banking sector, public debt, labour and migration policies, and growth model.

This November will mark the 25th anniversary of the Maastricht Treaty, which transformed the European Economic Community into the European Union; and next year is the 20th anniversary of the launch of the euro. Each institution has not just survived, but expanded, despite challenges such as Greece’s sovereign-debt crisis and the United Kingdom’s decision to quit the EU. But while the eurozone has weathered these storms, a series of unresolved issues still plagues it.

In recent years, growing nationalist and anti-immigrant sentiment has given rise to populist parties willing to challenge EU rules and defy the bureaucrats in Brussels. And since the 2008 financial crisis, many European banks have been on a wobbly footing, and sovereign, corporate and household debt levels in a number of European countries remain elevated. Though unemployment has fallen somewhat, it is still double the rate in the United States. And after a recent uptick, Europe’s overall economic growth rate has fallen once again.

Moreover, Europe’s population is aging, but attempts to roll back exorbitant transfers, high taxes and inflexible regulations have met with only limited success. A perfect example is French President Emmanuel Macron’s proposed pension, tax and labour-market reforms, which have provoked protests at every turn.

All told, Europe has long suffered from tepid growth, excessive sovereign debt, which will become more burdensome when interest rates finally rise, and weak, inefficient banks. And, looking ahead, further trouble in the banking sector could prove particularly challenging, given that well over half of all credit extended in the EU comes from banks, a share that reaches 70 per cent in Germany and Italy. By comparison, just 35 per cent of credit extended in the US comes from banks.

Moreover, a number of eurozone countries’ continuing economic distress and weak competitiveness reflects their lack of a currency to depreciate. The loss of monetary sovereignty, combined with demographic strains and the migrant and refugee crisis, helps to explain why many voters have flocked to populist and nationalist parties. In Italy, the UK and other key member states, there is a growing hostility to common fiscal rules and such basic EU tenets as the free movement of people.

Europe’s problems tend to reinforce one another. Anemic growth makes it harder to sort out banks’ non-performing loans, which in turn further impedes growth, fueling public discontent. Even if Italy’s new government has ruled out a showdown over the euro in the near term, it will have to confront these economic issues. Tria claims that spending increases and tax cuts are not in the cards, but that is precisely the policy mix the coalition parties agreed to when they formed their government.

Voters in democracies frequently support spending increases and tax cuts, despite any impact on the country’s debt. But Italy’s public debt, at 130 per cent of GDP, is already the highest in Europe. If the authorities do end up flouting EU budget rules, other member states’ governments may be emboldened to follow suit, especially if there is domestic political pressure to do so. Owing to ultra-low interest rates, Italy has managed to keep its deficit under 3 per cent of GDP, in accordance with the EU’s Stability and Growth Pact. But when borrowing costs finally start to rise, Italy’s debt honeymoon will be over.

Making matters worse, a large share of Italy’s sovereign debt is held by its own wobbly banks. Italians have long been hostile to the EU’s “bail-in” directive, which calls for creditors to take a loss in the case of bank failures, because the ownership of Italy’s banks, which emerged from the country’s historic city-states, is heavily localised. Thus, the collapse of an Italian bank would severely damage the economy of the surrounding region, whereas the effects of a US bank failure would be far more dispersed.

Another area to watch is immigration. Since 2011, 750,000 migrants have arrived in Italy from across the Mediterranean. And now Matteo Salvini, the League Party leader and minister of the interior, is demanding that other EU countries, particularly France, accept more asylum seekers. After recently turning away a rescue boat carrying some 600 migrants, Salvini wrote on Facebook that, “Rescuing lives is a duty, transforming Italy into an enormous refugee camp is not.”

The Italian electorate’s growing hostility to immigration is part of a larger trend across the EU, from Hungary and Poland to the UK. Just before the Brexit referendum in 2016, then-British prime minister David Cameron made a last-minute appeal to German Chancellor Angela Merkel, imploring her to agree to a cap on the movement of people into the UK. Merkel refused, and the Brexit referendum passed by a narrow margin.

The irony is that Merkel is now facing the same anti-immigration backlash that Cameron did in 2016. Immigration tends to be good for an economy over the long term, especially if the ratio of retirees to workers is rising. But when the level of immigration exceeds a country’s capacity to absorb new workers, there can be severe economic and social costs, at least in the short term.

Across the EU, there are growing tensions between conceptions of local autonomy, national sovereignty and supranational authority. If Europe’s cyclical upturn does not translate into long-term sustained growth, then the quadruple threat of Italy’s banks, debt, immigration backlash and economic malaise will test the resilience of the single currency — and of European integration generally. Much will depend not just on Italy’s new government, but also on the fate of Macron’s reform agenda.

Michael J. Boskin, professor of economics at Stanford University and senior fellow at the Hoover Institution, was chairman of George H.W. Bush’s Council of Economic Advisers from 1989 to 1993. Copyright: Project Syndicate, 2018. www.project-syndicate.org