Italian Risks to the Eurozone

Home , Brothers of Italy, European political party, Forza Italia, Forza Italia (2013), Italian government debt

DESMOND LACHMAN AND RYAN NABIL FEBRUARY 2018

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AMERICAN ENTERPRISE INSTITUTE Executive Summary

taly, the eurozone’s third-largest economy, is due Being locked in the euro, Italy’s lackluster productiv- Ito hold parliamentary elections on March 4, 2018. ity performance has resulted in a large loss in interna- The importance of those elections for both Italy and tional competitiveness. the eurozone cannot be overstated. Italy is simply too The forthcoming elections seem unlikely to pro- large an economy to fail for the euro to survive. How- duce a coherent and reform-minded Italian govern- ever, it is also too large an economy for the eurozone ment that might decisively address the country’s to save. economic vulnerabilities. To date, markets have At the heart of Italy’s economic vulnerability is its turned a blind eye to these vulnerabilities in a favor- seeming inability to generate meaningful economic able global economic environment of ample global growth or to improve its labor market productivity in liquidity. However, it remains to be seen how forgiv- a euro straitjacket. Over the past decade, the lack of ing markets will be when the external environment economic growth has contributed to a continued rise takes a turn for the worse and when the European in the Italian public debt-to-GDP ratio to a dangerous Central Bank discontinues its large government bond- level. It also has prevented the country from materi- buying program. ally improving the state of its shaky banking system.

1 Italian Risks to the Eurozone

Desmond Lachman and Ryan Nabil

taly, the eurozone’s third-largest economy, is due 5.5 percent, Italy’s has been stuck at more than Ito hold parliamentary elections on March 4, 2018.1 11 percent.2 Worse yet, Italian youth unemployment The importance of those elections for both Italy and remains close to 20 percent. the eurozone cannot be overstated. Italy is simply The euro has hobbled the Italian economy by pre- too large an economy to fail and for the euro to sur- cluding the country from resorting to exchange rate vive. Yet it is also too large an economy for the euro- depreciation to either restore international com- zone to save. For this reason, one has to hope that the petitiveness or boost its economy by lower interest forthcoming elections produce an Italian government rates when needed. This constraint has been par- much more committed to implementing far-reaching ticularly important in the aftermath of the 2008–09 economic reforms than previous Italian governments financial crisis when Italy’s public finances were seri- have been. ously eroded by a deep economic slump. The need At the heart of Italy’s economic vulnerability is its to undertake severe budget belt-tightening in a euro seeming inability to generate meaningful economic straitjacket contributed importantly to the country’s growth. This lack of economic growth has contrib- triple-dip economic recession and to today’s Italian uted to a continued rise in the Italian public debt-to- economy remaining around 5 percent smaller than its GDP ratio to a dangerous level, and it has prevented pre-2008 crisis peak.3 the government from materially improving the state Looking ahead, continued euro membership will of its shaky banking system. While markets might likely constrain Italy to many more years of poor eco- have turned a blind eye to these vulnerabilities in a nomic performance for a simple reason. Italy, which favorable global economic environment of ample cen- has consistently been a poor productivity performer, tral bank liquidity, it remains to be seen how forgiv- has tied itself in a monetary union to an economic ing markets will be when the external environment powerhouse such as Germany, which has consistently takes a turn for the worse and the European Central improved its labor productivity performance. This Bank (ECB) discontinues its large government-bond- disparity in productivity performance has resulted in buying program. Italy losing around 20 percent in labor market competitiveness to Germany (Figure 2).4 Unless Italy were to undertake fundamental economic reforms to The Euro Was a Big Mistake for Italy boost its productivity performance, it will likely continue to lose competitiveness to its northern Euro- Judging by Italy’s poor economic performance since pean economic partners. 2000, adopting the euro as its currency in 1999 was a While joining the euro seems to have been a sin- big mistake. Whereas German income per capita has gularly bad idea for Italy and seems to have clouded increased by around 20 percent since 2000, Italy’s has its economic outlook, leaving the euro at this stage actually declined by 5 percent (Figure 1). While Ger- does not seem to be a viable alternative for the coun- man unemployment has now been reduced to around try. Introducing a parallel currency, as former Prime

2 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure 1. Divergent Trends in Economic Growth (GDP per Capita, Constant USD)

1.25 Germany United States 1.20 United Kingdom

1.15 France

Spain 1.10

1.05

1.00 Italy

0.95

0.90 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Organisation for Economic Co-operation and Development, “Quarterly Growth Rates of Real GDP, Change over Previous Quar- ter,” https://stats.oecd.org/index.aspx?queryid=350#.

Figure160% 2. Italy’s Increasing Uncompetitiveness (Quarterly Unit Labor Costs)

150% United Kingdom

Italy 140%

France 130% Spain United States 120% Germany

110%

100%

90% Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20142015 2016 2017

Source: Organisation for Economic Co-operation and Development, “Unit Labour Costs,” https://data.oecd.org/lprdty/unit-labour- costs.htm.

3 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure5 3. Net Government Interest Costs (Net Debt Interest Payments, % of GDP)

0 Percentage of GDP –1

–2

–3 k s y l s lia a m ic ia d ce ce y el ly n a d d a lic ia n d e a ri iu da n n ny e ar nd nd a a a re rg d g ai en n om t re CD ra st bl o a an g la la sr It p o ou an an wa lan u b en la a a st lg na nmar t nl ma re e e I Ja K rl al rt u Sp ed r d St o Au pu Es Fi Fr r G un Ic Ir Po p ov w ze r OE Au Be Ca H mb he Ze Nor Po Sl S it ng d l Re De Ge e t Re Ki te Eu h x w ak Sw i ec Lu Ne v ed Un Tota z Ne lo it C S Un

Source: Organisation for Economic Co-operation and Development, “Economic Outlook Annex Tables,” http://www.oecd.org/ economy/outlook/economic-outlook-annex-tables.htm.

Minister Silvio Berlusconi has proposed in the past,5 vulnerable to a change in the global economic envi- would almost certainly raise the government’s bor- ronment for two basic reasons. The first is that Italy rowing costs, which already rank among the highest has made practically no progress in reducing its pub- in Europe (Figure 3). A further increase in borrowing lic debt mountain. The second is that it has failed to costs would certainly encourage deposits to leave Ita- improve the parlous state of its banking system. ly’s shaky banks. That in turn could very well trigger As an indication of Italy’s public debt problem, an Italian government debt default, which would have the country’s public debt amounted to more than major consequences not only for the Italian bank- €2.2 trillion in 2016 ($2.7 trillion), making it the ing system but also for the eurozone as a whole. This world’s third-largest government bond market.6 would seem to leave the country with little alternative Meanwhile, Italy’s public debt-to-GDP ratio has but to undertake major economic reforms to substan- risen to 134.7 percent,7 which is the eurozone’s tially improve its productivity performance, which is second-highest such ratio after Greece (Figure a necessary condition to get the euro to work for Italy. 4). That the average maturity of this debt is only around seven years heightens Italy’s vulnerability to a change in global financial market conditions.8 Two Major Economic Vulnerabilities This means that higher market interest rates would feed through relatively quickly to the country’s pub- Against the backdrop of the country’s poor economic lic finances. It also means that the country’s annual growth performance, the Italian economy remains gross government borrowing needs—at more than

4 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

15 percent of GDP—are high, which exposes it to any Political Headwinds drying up in global liquidity. The poor state of the Italian banking system’s bal- Most economists would agree that Italy needs faster ance sheet substantially constrains Italy’s economic economic growth if it is to resolve its public debt and growth. Because of many years in economic reces- banking-sector problems in an orderly manner. They sion, the banking system’s nonperforming loans would also agree that faster economic growth will have risen to around 17 percent of its balance sheet.9 only be achieved if the country were to have a strong At the same time, pressured by the government, government deeply committed to economic reform, the Italian banks’ holdings of Italian government especially of Italy’s highly rigid labor market. There bonds have now risen to around €380 billion ($464 also seem to be little disagreement that the last thing billion).10 This exposes the banks to any mishap in that the country now needs would be a government Italy’s public finances. It also leaves them with little whose commitment to both the euro and the Euro- room to increase credit to the private sector, which pean Union seemed to be tenuous. would seem to be a necessary condition for Italy to Sadly, the prospects appear poor that following the stimulate the sort of economic growth that might March 2018 parliamentary elections Italy will receive allow the banks to grow their way out of their non- a strong and reform-minded government. Indeed, the performing loan problem. latest electoral polls suggest that support for the ruling

Figure 4. Italian Government Debt to GDP

160

140

120

100

Percentage 80

20 11 11 61 71 81 91 01 21 31 41 51 61 71 81 91 16 16 01 66 76 86 96 06 26 36 46 56 66 76 86 96 06 19 18 18 18 18 19 19 19 19 19 19 19 19 19 20 19 18 18 18 18 19 19 19 19 19 19 19 19 19 20 20 20

Source: Francese Maura and Angelo Pace, “Il debito pubblico italiano dall’Unità a oggi. Una ricostruzione della serie storica,” Banca d’Italia, 2008; and Eurostat, “Government Finance Statistics (EDP and ESA 2010),” http://ec.europa.eu/eurostat/web/ government-finance-statistics/data/main-tables.

5 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure 5. Opinion Polls Show the Five Star Movement Is the Leading Party

0 April 8April 14 Five Star Movement Democratic Party Forza Italia League Free and Equal Party/Former Le -Leaning Coalitions Brothers of Italy

Source: Authors’ calculations.

Democratic Party, which is the country’s only main commitment to economic reform and its continued pro-European political party, has slumped to under euro membership. 25 percent of the vote. Meanwhile, the populist Five The commitment of the next Italian government to Star Party, which is hardly known for its economic the euro is likely to be more tenuous than was that of reform or pro-European credentials, has now pulled the previous government. This is especially the case ahead of the Democratic Party in the polls (Figure 5 considering that only 45 percent of Italians believe the and Appendix A).11 euro is a good thing for their country, comprising the The most likely political scenario is that the lowest rate of approval in any EU country (Figure 6).12 March 2018 parliamentary election will produce a Berlusconi’s Forza Italia keeps talking about the need weak Italian coalition government comprised of for a parallel currency, while the Northern League is strange bedfellows incapable of delivering the eco- even more robust in its opposition to the euro. For its nomic reforms that the country so desperately part, the Five Star Movement has recently toned down needs. A potential center-right coalition comprised its rhetoric on discontinuing Italy’s euro membership. of Forza Italia, the Northern League, and Brothers of However, judging by its past performance, one cannot Italy could achieve a parliamentary majority. How- exclude the Five Star Movement from switching back ever, one cannot exclude the possibility that the Five to its anti-euro position following the election. Star Movement will find the way to form a coalition Beyond raising questions about Italy’s European government. If that were to occur, it is bound to commitment, a new coalition government could cast raise serious questions in the markets about Italy’s doubts on the country’s commitment to budgetary

6 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure 6. Italian Sentiment Toward the EU Slides

55 centage r

Pe 50

30 2007 2008 2009 2010 201120122013 201420152016 2017

Source: European Commission, “Public Opinion,” http://ec.europa.eu/COMMFrontOffice/publicopinion/index.cfm/Survey/ getSurveyDetail/instruments/FLASH/surveyKy/1092.

discipline. Particularly disturbing is the fact that the purchases and intimated that it might end such bond Northern League, Brothers of Italy, and the Free and buying by September 2018. Equal Alliance all want to introduce a more generous pension system for Italians. Meanwhile Forza Italia and the Five Star Movement want to introduce uni- Italy Is Not Greece versal income support for the poor. At a time when Italy’s debt-to-GDP ratio is the second highest in A struggling Italian economy could threaten the the eurozone, the last thing Italy needs is a further euro because of its size. With Italy being around increase in its budget deficit and public debt. 10 times the size of the Greek economy and having These economic policies, along with uncertainties the eurozone’s third-largest economy, it is difficult to about Italy’s future commitment to the euro, could imagine that the euro could survive in anything like very well raise investors’ doubts as to the country’s its present form if for any reason Italy were forced out ability to stay the course. This would be particularly of the euro.13 the case should global liquidity conditions tighten as Similarly, since Italy’s economy is significantly the world’s major central banks move to normalize larger than that of Greece, it is difficult to imagine their monetary policies. To date, Italy has benefited that Europe could come up with a sufficiently large importantly from the ECB’s bond-buying program bailout package to keep Italy in the euro were it to and from low European interest rates. However, the come under sustained speculative attack or experi- ECB has already halved the monthly rate of its bond ence a real bank run. This would particularly seem to

7 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

be the case considering German Chancellor Angela About the Authors Merkel’s weakened position following her setback in the September 2017 German parliamentary elections. Desmond Lachman is a resident fellow at AEI, where Italy’s crashing out of the euro is certainly not pre- he focuses on the global macroeconomy, global cur- ordained. However, absent real economic reform that rency issues, and the multilateral lending agencies. might put the country on a faster economic growth Ryan Nabil is a financial services and global mac- path, there is an appreciable risk that in time this roeconomy researcher with AEI’s Economic Policy could happen. For this reason, one must hope for Studies department. both Italy’s and Europe’s sakes that the forthcoming Italian parliamentary elections produce a united government committed to serious economic reform and making the euro work for the country.

© 2018 by the American Enterprise Institute. All rights reserved. The American Enterprise Institute (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and does not take institutional positions on any issues. The views expressed here are those of the author(s).

8 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Appendix A

Table A1. Italy’s Political Parties and Their Economic Agendas PARTY MAIN POLICY AGENDA Democratic Party • It leans center-left and is social democratic and pro-EU. • Negotiate with the European Union to abolish the EU’s fiscal • It was founded in 2007 and has been in power since 2013. compact, which requires Italy to run lower deficits and trim its • Paolo Gentiloni is the current head and nominee for 2018 high debt levels. election; the former prime minister and current Democratic • Raise the budget deficit above 3 percent of GDP to cut taxes Party leader, Matteo Renzi, is also seeking reelection. and increase investments. • It traditionally supports immigrant, but Renzi’s recent hawkish • Continue Italy’s social and foreign policy, especially its current rhetoric toward migrants has caused discontent in the party. membership of NATO.14

Five Star Movement • It is populist, antiestablishment, and pro-direct democracy. • Introduce universal income support to ensure a monthly • It was cofounded in 2009 by comedian Beppe Grillo and is income of €780 ($953) for all Italians. now the main opposition party. • Raise the budget deficit above 3 percent of GDP to cut taxes • “Five Star” refers to five key issues: public water, sustainable and increase investments. transport, sustainable development, right-to-internet access, • Raise taxes on Italian banks and oil and gas companies. and environmentalism. • Renegotiate the Fiscal Compact. • It is bipartisan—left-leaning voters support the Five Star • Repeal 2011 pension reform to allow earlier retirement and Movement for being pro-environment, anti-austerity, and 2014 labor reform to make firing harder. anti-capitalist. Right-leaning voters support the Five Star • Scrap unnecessary bureaucracy and design new Movement for being euroskeptic and anti-immigration. immigration policies.15 • It previously sought reforms to euro and an end to fiscal compact, but Luigi Di Maio, the party’s current leader, has softened the party’s stance on Europe and euro membership.

Forza Italia (FI) • It is center-right, liberal conservative, and pro-EU. • Introduce a “parallel” Italian currency for domestic use while • It allied with traditional right-leaning parties—the Northern using euro for international trade and tourism. League and Brothers of Italy—against the Democratic Party • Create a single rate flat income tax rate of 23 percent for and Five Star Movement. individuals and companies. • Former Prime Minister Silvio Berlusconi is back as the party’s • Abolish housing tax, inheritance tax, and road tax on candidate for the election. most cars. • Guarantee a minimum income of €1,000 per month ($1,222) for all Italians. • Block the arrival of new immigrants through treaties with North African countries.16

9 ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Table A1. Italy’s Political Parties and Their Economic Agendas (Continued)

PARTY MAIN POLICY AGENDA The Northern League (LN) • LN was founded in the early 1990s as a separatist party, • Introduce parallel currency for domestic use while keeping which campaigned for independence of Padania in the euro for international trade and tourism. northern Italy. • Abolish Fiscal Compact and eventually leave the euro. • It favors federalism and euroskepticism. • Introduce flat tax of 15 percent for individuals and companies. • It is part of center-right coalition with Forza Italia and Brothers • Repeal 2011 pension reform to allow earlier retirement. of Italy but has disagreed with Forza Italia on whether Italy • Crack down on illegal immigrations, send back migrant boats, should leave the euro. and repatriate up to 100,000 immigrants per year.17 • It organized two autonomy referendums in Lombardy and Veneto in 2017. • It campaigned in the past for a referendum on EU membership. • It changed the party’s name from the Northern League to the League to reflect its national—rather than regional and separatist—ambitions.

Free and Equal • The Senate president launched the alliance of left-wing • Repeal 2014 labor reforms to make firing harder. political parties and defectors from the Democratic Party in • Soften 2011 pension reform to stop automatic increases in December 2017. retirement age. • The founding parties of the alliance are associated with dem- • Increase spending on education, health care, ocratic socialism and social democracy. However, they have and infrastructure. framed themselves as “the left” to avoid internal divisions. • Introduce free university education.18

Brothers of Italy • It originated in 2012 to oppose Mario Monti’s technocratic • Renegotiate all EU treaties including the fiscal compact government. and eurozone. • The founding members belonged to the National Alliance, the • Increase support for Italy’s law enforcement and successor to Italy’s neofascist parties.19 armed forces. • It favors nationalism, national conservatism, and • Reduce taxes and bureaucracy. euroskepticism. • Enforce immigration laws and tougher penalties for • It is in a center-right coalition with Forza Italia and Northern violent crime.20 League. Its policies are similar to the Northern League, but with support based in Central and Southern Italy.

Source: Authors.

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Notes

1. John Follain and Chiara Albanese, “Italy’s President Dissolves Parliament, Triggering Elections,” Bloomberg, December 28, 2017, https://www.bloomberg.com/news/articles/2017-12-28/italy-s-president-dissolves-parliament-triggering-elections. 2. Organisation for Economic Co-operation and Development, “Selected Indicators for Italy,” https://data.oecd.org/italy.htm. 3. Organisation for Economic Co-operation and Development, “Quarterly Growth Rates of Real GDP, Change over Previous Quar- ter,” https://stats.oecd.org/index.aspx?queryid=350#. 4. Organisation for Economic Co-operation and Development, “Unit Labour Costs,” https://data.oecd.org/lprdty/unit-labour- costs.htm. 5. Reuters Staff, “EU Shoots Down Berlusconi Parallel Currency Proposal,” August 23, 2017,https://www.reuters.com/article/us- italy-currency-berlusconi-commission/eu-shoots-down-berlusconi-parallel-currency-proposal-idUSKCN1B32BP. 6. Eurostat, “Government Debt Up to 89.5% of GDP in Euro Area,” July 20, 2017, http://ec.europa.eu/eurostat/documents/2995521/ 8118661/2-20072017-AP-EN.pdf/83147478-c193-40e9-8a0a-b76e56a5cebc. 7. Eurostat, “General Government Gross Debt—Quarterly Data,” http://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1& language=en&pcode=teina230&plugin=1. 8. European Central Bank, “The Size and Composition of Government Borrowing in the Euro Area,” May 2010, https://www.ecb. europa.eu/pub/pdf/other/mb201005_focus04.en.pdf?a09af0170bd1d12f1eb8ba4c8a9baa6e. 9. World Bank, “Bank Nonperforming Loans to Total Gross Loans,” https://data.worldbank.org/indicator/FB.AST.NPER.ZS?end=2016 &start=2005&view=chart. 10. European Central Bank, “Balance Sheet Items,” http://sdw.ecb.europa.eu/browseExplanation.do?node=qview&SERIES_KEY=117. BSI.M.IT.N.A.A30.A.1.U2.2100.Z01.E. 11. Francesco Anania and Emanuele Vena, “Electoral Political Polls,” Termometro Politico, https://www.termometropolitico.it/ sondaggi-politici-elettorali. 12. European Commission, “Public Opinion,” http://ec.europa.eu/COMMFrontOffice/publicopinion/index.cfm/Survey/ getSurveyDetail/instruments/FLASH/surveyKy/1092. 13. World Bank, “GDP (Current US$),” https://data.worldbank.org/indicator/NY.GDP.MKTP.CD. 14. Reuters Staff, “Factbox: Italy’s Election—Parties, Leader and Programs,” Reuters, December 28, 2017, https://www.reuters.com/ article/us-italy-election-parties-programmes-fac/factbox-italys-election-parties-leaders-and-programs-idUSKBN1EM1HE. 15. Reuters Staff, “Factbox.” 16. Reuters Staff, “Factbox.” 17. Binnie, “Italy’s Norther League Pledges to Put Right ‘Error’ of Euro.” 18. Reuters Staff, “Factbox.” 19. Edwards, “An Introduction to Italy’s Small Political Parties.” 20. Fratelli d’Italia, “The FDI-AN Program for the European Elections 2014,” http://www.fratelli-italia.it/programma-europa/.