Chronic inability to separate the probable from the desirable has been the tragedy of 2016. Wishful thinking is becoming a threat to the survival of liberalism itself.
This tendency is especially evident in the discussion about Italy’s future in the euro zone. The complacent now say that Italy is good at muddling through, that the establishment can always stitch up the electoral system to prevent a victory by an extremist party. In any case, the Italian constitution does not allow for a referendum on leaving the euro. So it cannot happen.
Really? I don’t think so. Start with the discrepancy in economic performance between Germany and Italy. One metric is the imbalances within Target 2, the euro zone’s payment system.
At the end of November these reached higher levels than during the height of the euro zone crisis in 2012. Germany’s surplus is at €754 billion, while Italy’s deficit is at €359 billion. A part of the imbalances relates to the European Central Bank’s programme of quantitative easing and is thus harmless. But the bulk is due to what might be described as a silent bank run.
Lack of sustainability does not necessarily imply exit. It is possible, in theory, that the political will over-rides the economic needs forever. Or that the unsustainable could be rendered sustainable. For that to happen, at least one of five conditions would have to be fulfilled.
First, Italy and Germany could converge. To do this, Italy would need to undertake economic reforms to clean up the justice system and the public administration, cut taxes and invest in productivity-increasing technologies. Germany would need to run a higher fiscal deficit.
Second, the northern European states accept large fiscal transfers to the south.
Third, the EU creates a federal political authority with powers to raise taxes in order to transfer income from high-income earners to low-income earners.
Fourth, the ECB finds a way to bankroll Italian public and private debt indefinitely.
Or fifth, Italy’s government will forever continue to support euro membership.
Only one of those five conditions may be sufficient for Italy to remain a member of the euro. The problem is that each one is extremely improbable. And I cannot think of a sixth one.
Matteo Renzi’s economic reforms have been insignificant, apart from a smallish labour reform package. The outgoing Italian prime minister chose to focus on political reforms instead and lost when the referendum returned a 60 per cent No vote.
After his failure, a reformist government is not in sight. The selection of Paolo Gentiloni to replace Renzi is not going to change that. His government, after all, has a very narrow mandate.
I also cannot see Germany bailing out the euro zone either before or after next year’s national elections. The country’s constitution requires a balanced budget. No other northern state is willing to accept large fiscal transfers, let alone a political union.
What about the European Central Bank (ECB)? Last week, it extended its quantitative easing initiative until the end of 2017. The programme has helped Italy, but it will not be sufficient to bankroll the country indefinitely, especially given the small size of the programme relative to the total outstanding public debt.
This leaves us with Italian politics. Of the three large party groups, only the centre-left Democratic Party (PD), Renzi’s party, is pro-euro. There is a theoretical possibility that a resurgent PD might win the next election.
I am not sure this will happen but I am sure that the PD cannot remain in power indefinitely. One day Italy will be led by a party in favour of withdrawal from the euro. When that happens, euro exit would turn into a self-fulfilling prophecy. There would a run on Italy’s banks and its government’s bonds.
Italy’s fate in the euro zone and the possibility of a President
Marine Le Pen
of France are two large threats to the euro zone and the EU. If Italy wants to stay in the euro, it needs to send a clear warning to Germany and the other northern European countries that the euro zone is set on a path of self-destruction unless there is a change of parameters.
The next Italian prime minister will need to explain to the next German chancellor, presumably Angela Merkel, that her choice will not be between a political union or no political union, but between a political union or Italy's withdrawal from the euro.
The latter would imply the biggest default in history. The German banking system would be in danger of collapsing, and Europe’s biggest economy would lose all the competitiveness gains so painstakingly accumulated over the past 15 years.
It has been the historic failure of consecutive Italian prime ministers to avoid this necessary confrontation and to think that staying off the radar screen constitutes a viable strategy.