How The Resignation of Italy’s Prime Minister Threatens the European Union and The Global Economy
This is updated version of an earlier post on the Italian mini-BOT plan
Last Tuesday the Italian prime minister, Gieseppe Conte, resigned. His resignation is likely to end in the dissolvement of parliament triggering elections three and a half years ahead of schedule. The implications of this are potentially catastrophic for the future of the European Union.
Conte’s downfall is seen as orchestrated by Matteo Salvini, the head of the right-wing League party. The possibility of elections this fall means that Salvini, whose party is soaring in opinion polls and just triumphed in the May European Parliament elections, may gain full control of the nation’s government.
Under the new election laws, put in place a few years ago to blunt the power of Euroskepic parties such as the League, one-third of parliamentary seats are allocated by first-past-the-post with the remaining two-thirds allocated proportionally. This keep these parties at bay initially, but now they have risen so much in the polls (the League was polling at 13% last year and is now polling at 37%) these rules will allow them to form a majority government without partners if they can achieve 40% of the vote.
The threat to Europe from the rise of the League is primarily from their plan to create a parallel currency for Italy called the mini-BOT. This idea is a threat to the existence of the eurozone – and the stability of the entire global economy.
While this idea is not a new one, with the rise of the League, it is something that must be taken seriously. Winning a majority in parliament will allow them to create the parallel currency that they've been talking about for years. Reuters Reported back in 2017 that:
The Northern League’s Borghi said Italy “has to be ready for the euro’s collapse,” which he sees as only a matter of time. He is the architect of the party’s proposal - which Berlusconi has also hinted he would support - called “mini-BOTs”, named after Italy’s short-term Treasury bills.
Borghi says initially some 70 billion euros of these small denomination, interest-free bonds would be issued by the Treasury to firms and individuals owed money by the state as payment for services or as tax rebates. They could then be used as money to
pay taxes and buy any services or goods provided by the state, including, for example, petrol at stations run by state-controlled oil company ENI.
Issuing a currency in parallel to the Euro risks the breaking up the European monetary union - if only because having a parallel system in place would remove much of the pain from a transition. Europe's control over the euro, and threats to use that power to shut down Greece's banking system, is what forced the Greek populists to submit to austerity back in 2013. The Italians have obviously taken this lesson to heart - which is why the proposed parallel currency is causing such consternation in Europe.
The Last Two Decades Under the Euro
To really understand this issue - why the League would want to create a parallel currency and how that would be a threat to the global economy - we have to go back in time a few decades.
Since Italy joined the Euro, its economy has stagnated. Production moved to Germany where costs were lower - but that was aright with the Italians initially, because this was a slow process and euro membership came with some big perks.
For instance, when the euro was introduced, the bond market came to believe that all EU bonds had the same risk (essentially none) —and EU financial regulators allowed banks to treat Greek debt just like German debt—not even requiring any capital reserves against the risk of default until 2006 . The graph below shows how the yields from high risk debt issued by nations like Greece, Spain, and Italy converged to match France and Germany during this period.
So, from approximately 1998 to 2008, Italy, along with the rest of the nations in Southern Europe were able to borrow from the markets at a very cheap rate. Frankly an unwarranted rate. And borrow they did.
The European Sovereign Debt Crisis
But then you had the Great Recession. And by 2010 the nations of Southern Europe were in a full-blown Sovereign Debt Crisis. The market realized that there was a substantial risk these nations could not pay their debts, and so, quite suddenly, the interest they demanded to lend to these countries rose dramatically.
For Greece it went from less then 5% to almost 30% in the span of a few months.
This crisis has not been resolved. In fact, today Greece’s debt to GDP ratio is significantly higher than what it was before the crisis.
As is Italy’s. In truth, the situation is even less sustainable than it was in 2010 - but the reckoning has been delayed.
The European Central Bank (ECB) purchased the bonds of Greece and the other troubled nations and pushed their yields down artificially with quantitative easing (QE). This lead to a host of problems – like zombie companies – but it allowed these nations to at least make interest payments on their debt. Rates have gotten so low that in May 2019 the yield on US treasury five year bonds were higher than on Greek five year bonds. That means the US had to pay more interest to borrow than Greece. Not because Greek debt has less risk of default than US debt, but because the yield has been artificially manipulated lower. The ECB has continued to purchase the bonds of European countries -propping up their value and preventing a systematic collapse of the European banking system.
A sovereign debt crisis is much more serious than your typical banking crisis – because there is no entity that can really bailout a country the size of Italy. When the US housing market crashed the government bought the bad debt and bailed out the economy. As bad as it was, the Great Recession would have been so much worse if the banking system did not get bailed out. But for a sovereign debt crisis you can’t bailout all the debt – it’s just too much and no nation wants to take responsibility for it.
Mervyn King, the Bank of England Governor (equivalent to the Federal Reserve Chairman Jerome Powell) at the time of the crisis, explained that:
Dealing with a banking crisis was difficult enough, but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there’s no backstop .
But, the important thing to understand is that this was not just a crisis for Greece, Italy, and the rest of Southern Europe. As John Maynard Keynes said, “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.” Greece owed billions of euros to French and German Banks. If Greece could not pay, not only Greece, but the French and German Banking systems would be insolvent.
Former Greek finance minister Yanis Varoufakis has denounced the rescue plan that was created for Greece as a modern version of the Versailles Treaty. In his 2017 book, Adults in the Room, detailing his time as Greek finance minister at the height of the crisis, he wrote:
Greece’s endemic underdevelopment, mismanagement, and corruption, explain its permanent economic weakness. But its recent insolvency is due to the fundamental design faults of the EU and its monetary union the euro…While the drachma devalued, these deficits were kept in check. But when it was replaced by the euro, loans from German and French banks propelled Greek deficits into the stratosphere.
The Credit Crunch of 2008 that followed Wall Street’s collapse bankrupted Europe’s bankers who ceased all lending by 2009. Unable to roll over its debts, Greece fell into its insolvency hole later that year. Suddenly three French banks faced losses from peripheral debt at least twice the size of the French Economy…For every thirty euros they were exposed to, the had access to only one…The same three French bank’s loans to the Italian, Spanish and Portuguese governments alone came to 34 percent of France’s total economy…If the Greek government could not meet its repayments, money men around the globe would get spooked and stop lending to the Portuguese, possibly to the Italian and Spanish states as well, fearing that they would be the next to go into arrears. Unable to refinance their combined debt of nearly €1.76 trillion at affordable interest rates, the Italian, Spanish and Portuguese governments would be hard pressed to service their loans to France’s top three banks…
German banks had the same issues as the French banks. The crisis in Southern Europe threatened to destroy the economies of every nation in Europe. The solution, was to ensure that Greece did not default and cause a domino effect throughout Southern Europe. The EU provided a rescue fund for Greece which essentially amounted to providing them a loan with which they could service their existing loans to their French and German creditors. But there was no restructuring of the debt owed to the foreign banks.
This so called bailout, and the austerity measures that went with it were put to the Greek people in a referendum on July 5th 2015, which was promptly defeated at the polls. However, the EU essentially threatened to shut down the Greek banking system if Greece did not accede. ATMs would not provide cash, depositors would be unable to access their bank accounts, and the Greek economy would collapse overnight. And not a collapse like the depression-level economic turmoil the country was already experiencing - an economy without a currency would be a true collapse. The Wall Street Journal reported days after the referendum, on July 12th 2015:
Europe’s ultimatum to Greece, demanding full capitulation as the price of any new bailout, marks the failure of a rebellion by a small, debt-ridden country against its lenders’ austerity policies, after Germany flexed its muscles and offered Athens a choice between obeisance or destruction.
Sunday’s statement on Greece by eurozone finance ministers will go down as one of the most brutal diplomatic démarches in the history of the European Union, a bloc built to foster peace and harmony that is now publicly threatening one of its own with ruination unless it surrenders.
While the measures have allowed the European system to maintain the fiction that Greece and the rest of Southern Europe can repay their debts, the impact on Greece has been nothing short of horrific. Under the austerity plan, the country has not managed to substantially reduce its debt. In fact Greece’s debt to GDP ratio has jump from 112% in 2007 to over 188% by 2017. Loans have been extended - not restructured or forgiven. The nation was forced by the EU to enact twelve rounds of tax increases, spending cuts, and reforms - sparking riots and nationwide protests. In many ways the situation in Greece has surpassed the Great Depression in the United States. With Greek unemployment spiking higher and lasting longer than in the United States during the 1930s’ Great Depression.
Greece’s minimum wage was cut by twenty-two percent. Pensions have been reduced forty percent. The national healthcare budget was slashed by roughly forty percent as well. Suicides have more than doubled since the crises began. Even Infant mortality rates which had been falling for decades have increased thirty-four percent in recent years. Despite all this, Greece has not moved to a sustainable fiscal position, only managed to continue to service its debt to its creditors
The Greeks were forced to give into austerity plans, because the Europeans threatened to shut down their banking system. Freeze all currency. Greece did not control is own currency so their economy would have collapsed.
Rise of Populism In Italy
So that’s the background to the situation today. The sovereign debt crisis that began in 2010 remains just under the surface. Since 2010 the ECB has used unconventional monetary policy to drive long-term bond yields to ultra low rates. This has allowed Greece, and Italy and the rest of the nations in Southern Europe to pay the interest on their debts. But even with these low interest rates, Debt to GDP has increased substantially.
Combined with these low interest rates have been harsh austerity measures. This austerity has stunted growth for almost a decade throughout Southern Europe.
For the last twenty years Italy’s average annual growth rate has been zero. Italy's unemployment rate has been over ten percent for the last seven years -with youth unemployment over thirty percent. Its hardly surprising that Italy has voted in a populist government opposed to austerity.
Up until last week the nation was governed by a coalition of left-wing and right-wing populists who’s 2019 budget plans to cut taxes and further lower the retirement age. Their budget plans have brought the populist parties into conflict with the rest of the EU over their budget. And now they are proposing they can pay for their plans by issuing their own parallel currency.The New York Times reported that:
...one proposal has caused particular consternation and raised fresh concerns that Italy, the third largest economy in the eurozone, could blow up the entire bloc. That land mine, critics say, is called the mini-BOT
Northern League’s economics spokesman Claudio Borghi told reuters:
With a parallel currency in place, if we want to leave the euro our economy will still be able to operate even if the European Central Bank tries to crush us by shutting off liquidity in euros.
Former IMF deputy director Desmond Lachman recently laid out the unenviable situation that Italy finds itself in today:
Italy’s basic policy dilemma boils down to a choice between two unattractive options. Should Italy try to stimulate its economy through an expansionary fiscal policy even though that might give fuel to the country’s bond vigilantes who are already concerned about Italy’s budget deficit and its very high public debt-to-GDP ratio?
Or should Italy again try to address its shaky public finances with budget austerity even though that risks deepening any economic recession? Such a deepening in turn might raise serious questions about the country’s ability to service its public debt mountain.
All of this suggests that Italy could be heading soon for a sovereign debt crisis that could have serious implications for the global economy. Being 10 times the size of the Greek economy and having the world’s third-largest sovereign debt market, Italy has the real potential to trigger a global financial market crisis .
In an interview for my new book, Sleeping on a Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications , Lachman expanded on his concerns for Italy in greater detail, saying:
This is really kind of quite a big deal… Italy is ten times the size of the Greek economy. And it has ten times the amount of debt. We saw when there was a Greek debt crisis back in 2010, that it really had big implications for the global economy. People got really very unsettled. Markets were very stressed. But Italy is ten times the size of Greece, so if Italy were to default on its debts that would be a major event.
Lachman also raised concerns about Itay’s current proposal to issue a type of parallel currency to the euro, a move that would be perceived as a major step towards leaving the euro. He said:
If Europe broke up that would be like a nuclear bomb going off in the middle of Europe - it would really be a disaster. If the euro were to break up Italy would certainly default on its debt. because the interest rates in Italy would just shoot up. If that were the case, you’d have a lot of banks that are holding Italian paper - a lot of the French banks are holding Italian paper - they’d be in deep trouble. It would be an event like Lehman blowing up.
Looking at the demographics for Europe, and the size of the debt burdens in the continent, it seems unlikely that Europe will be able to stabilize its debt in the coming decades. It remains to be seen if this parallel currency issue will be the factor that brings down the monetary union, but in the long run it seems inevitable that the monetary union cannot survive.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications,
Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.