Italy is storing up trouble for the eurozone

11/3/2018

By Wolfgang Münchau

A Five Star government could derail talks on reform of the single currency bloc

Almost a year ago I was invited by the Five Star Movement to a conference in the Italian chamber of deputies in Rome. The discussion was about whether or not Italy should leave the eurozone, and how to do this. Most of the speakers, myself included, argued in favour of unconventional policies, but stopped short of advocacy of outright eurozone withdrawal.

In the front row of the audience sat Luigi Di Maio, the party’s parliamentary leader. He followed the rather technical debate for an entire day. Not long after that conference, he dumped his party’s rather silly proposal of a referendum on eurozone membership. I do not think it is silly to question the wisdom of Italy’s eurozone membership as such. But a referendum is the wrong instrument. Any prime minister who called such a referendum would create an immediate financial crisis. The government would be forced to exit long before the country would exit the currency area.

After his party’s success at the general election on March 4, Mr Di Maio has a good chance of ending up as the next Italian prime minister. He is now positioning himself as a centrist in search of a coalition partner. What is his euro strategy now?

The euro referendum is mercifully off the table. But it is possible, indeed likely, that the next Italian government could derail the Franco-German talks on eurozone reform.

We learnt this week that eight small northern European countries, led by the Netherlands, are opposing those reforms because their governments reject the idea of fiscal transfers. Italy, too, has reasons to resist them, albeit different ones. The reforms would strengthen the role of the European Stability Mechanism, the €500bn bailout fund created in 2012 at the height of the crisis in the eurozone. But as a quid-pro-quo, Germany and others insist on semi-automatic debt restructuring. No Italian government could sign up to this. There is now a clear risk that the reform package proposed by Emmanuel Macron, the French president, might fail or, at best, turn out to be rather modest. It used to be that Franco-German agreement was both necessary and sufficient for any EU reforms to get through. That is no longer the case.

Another risk is an Italian fiscal overshoot. This is a very probable scenario, no matter whether Mr Di Maio becomes prime minister, or the job goes to Matteo Salvini, the leader of the anti-immigrant and anti-euro League.

The two parties were the big winners in the election. Five Star wants a universal basic income, one of the reasons for its electoral success among young people in particular. The League favours a flat tax. Since neither party advocates spending cuts to offset these measures, their fiscal proposals are not going to be consistent with the EU’s deficit rules.

The fiscal overshoot could fuel debate about a parallel currency as a soft alternative to a euro exit. There is a lot of excitement among some Italian economists about “fiscal money”, as it is also known. The idea is to use the tricks of modern finance to create something that performs functions resembling those of money, but that remains outside the control of the central bank.

Readers might recall that one of the more notorious instruments involved in the great financial crisis was the credit default swap, a tradable security that simulated insurance. An investor would typically buy a CDS to insure against the default of a corporate or a sovereign bond.

Fiscal money is technically different. But the idea of using one instrument to simulate another is similar: the Italian government would formally issue a credit note and transfer it to each citizen, say €1,000 per person. People could use it to pay their taxes or trade the notes at a discount. There would be a market because notes are eligible to settle tax debt.

I assume the rest of the eurozone, and the European Central Bank, would hate the idea because it undermines the notion of the euro as the single currency. Yanis Varoufakis, the former Greek finance minister, came up with the notion before the Greek debt crisis in 2015. Greece was not ready for it, and Alexis Tsipras, Greek prime minister, preferred a classic bailout programme. But the idea could see a comeback in Italy. Even Silvio Berlusconi, the former prime minister, came out in favour of a parallel currency before the elections.

So we are looking at three foreseeable outcomes for the eurozone: a string of vetoes on reform; an Italian fiscal overshoot; and a parallel currency as the harbinger of a future monetary fracture. This is in addition to the appointment of a hawkish successor to Mario Draghi as president of the ECB.

My conclusion, therefore, is that Italy will remain the principal source of risk for the eurozone for the foreseeable future.

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