Italy is back in the headlines and dominating market direction again. It is not the first time, but it has been a while since Italian politics were able to feed broader worries over sustainability of the Eurozone project. And the latter is the core reason why markets are responding more forcefully than they have done in years. Despite all Italy’s problems in terms of political instability, lack of structural reform and lingering debt burdens, it is really only when developments in Italy start to increase the probability of a Eurozone break-up that markets start to worry seriously.
Not because the other problems are not serious. However, they are judged by markets to not being able to derail economic trends in either Europe or Italy unless they are combined with a Eurozone break-up over the next 12 to 18 months. And markets rightfully know they cannot know anything about events further out!
With now some increased worries over a potential Eurozone break-up some might wonder again if it is the euro itself that is the problem. For the region as a whole it is however hard to argue that the currency union is creating economic underperformance. It is certainly an incomplete union and more institutional repairs are needed to make it work, as was imagined at the start of the project. However, the economic, legal or institutional infrastructure of other major economies, like the US or China, is not perfect either. And simply comparing GDP growth per capita between the Eurozone and the US only shows an outperformance of the US by 0.1%-point y-o-y since the introduction of the euro nearly two decades ago.
At the same time it might be that the euro has added to the fragility in the Eurozone economic system. The large intra-European imbalances were partially created by savings that got an extra incentive to flow North to South in the Eurozone. A more volatile business cycle, more extreme market evolutions (low interest rates in the North, high sovereign spreads in the South) and more systemic fragility during the euro crisis from 2010 till 2013 partially resulted from that. To some extent this probably also added lower public support for the Eurozone project and a rise of populism in the region, something clearly also seen in Italy.
The majority of Italy’s problems are however of its own making. A combination of low labour market participation and low productivity growth has kept potential growth very low. Both are long-standing problems that are hard to relate back to the introduction of the euro. They are more related to cultural and institutional factors, regulatory and income/tax incentives. Still, both also offer a lot of potential to improve if labour and judiciary reforms are finally made, red-tape is cut, product and goods market liberalisation is pursued and consolidation in the corporate sector is allowed more. For that potential to be unleashed, however, a lot of political capital has to be spent.
However, the latest election results, the proposed policies by the strongest political parties in Italy and the recently erupted political crisis all suggest that political capital will not be invested in the direction of reforms and stronger future potential growth. Even if the latest part of political drama in Italy, whereby the formation of a new government between the Five Star Movement and Lega Nord was put at risk by President Mattarella. By not allowing a euro-sceptic candidate (Paolo Savona) to become Minister of Finance in the new government it looked earlier in the week that new elections might be in the offing. At this point, however, there are renewed attempts to get a new government after intensive discussions between all stakeholders involved and the Italian President allowing for more time to finish the process.
For markets this will be crucially important because even a populistic government now carries substantial lower risk of future Eurozone break-up than highly uncertain elections later. Not in the least because the potential campaigns and final results could well be even more anti-establishment and less tolerant of Eurozone participation. And as said, euro break-up risk will matter most for markets in the near term. In the long term, both markets and the economy will have to digest that potential growth prospects are unlikely to brighten any time soon, in whatever political scenario we finally end up. The Italian job is far from finished.