A GHOST FROM THE PAST …

It was several years ago that investors worried aloud about a “meltdown” of the Eurozone. Greece was the “whipping boy” of Europe with Portugal, Spain and Italy as clubmates. The strong from northern Europe (think Germany and the Netherlands) lectured almost daily their Mediterranean cousins about their spending habits and lack of productivity. The Eurozone came close to dissolution except for the actions of the European Central Bank (ECB) and its forceful leader Mario Draghi who declared that the ECB would do anything and everything in support of the Euro – which was enough for markets. The Eurozone survived to fight another day.

That day may have arrived. It is not Greece this time which is the “bad boy”. Interestingly, Greece survived its program of economic reform and is about to emerge from the “penalty box” with a rejuvenated economy, at least for now. Rather, it is Italy, which recently elected populist candidates from two parties, that seems a bit of a “jumble”. Now while Italy never quite hit the economic shoals as hard as Greece in the last recession, it was a badly wounded economy which has since not fully recovered its old swagger. Unemployment is still five percentage points above its rate in 2007. Worker productivity is still hamstrung by archaic labor rules. Living standards are no higher than they were two decades ago. Emigration by Italians has more than doubled recently as Italians see no opportunity in their homeland.

In frustration, Italians have given no party in their parliament enough of a majority to rule. Rather, they have left their politicians with the task of forming a coalition and the two leading parties trying to form this political joint venture are both populist. Policies they advocate seem ruinous for Italy’s economy. One party wants to cut taxes to 15% for individuals, which would obviously cut government revenues. The other wants to have a guaranteed monthly income paid by the government to its citizens, thus ballooning government expenses. Infrastructure expenditures would be increased. Both parties are skeptical about the value of the Euro (€). Both parties want to scrap sanctions against Russia. This is all being talked about when Italian national debt is 130% of GDP – talk about highly levered!

Why is this of any consequence? Italy is the third largest economy in the Eurozone. Some would say it is too big to “bail out”. So, if for political reasons investors began to lose faith in Italian paper, the Italian “problem” could become a big problem. Spillover effects on other Eurozone economies could derail progress being made in other “weaker” countries like Spain, Portugal and Greece. Investors would probably scamper to German Bunds, driving down yields there but raising them elsewhere where there is a perception of higher risk. Further, Italy’s troubles would be much more of a risk to the Euro (€) than Greece’s problems ever were, because Italy is so much larger an economy.

Campaigning is not governing. Politicians say all sorts of things to get elected and then once in office, facing reality, govern in a different way. We hope this will be the course for the Italians. If not, if the populists stay true to their slogans, then the Eurozone and the Euro could face their demise and this would be unsettling to markets around the world.
Author’s Note: Since this commentary was written on May 28,2018 the President of Italy vetoed the Populists’ party candidate for Economy Minister and as a consequence: the attempt by the Populists to form a government has collapsed, the Italian President has appointed a technocrat as Prime Minister, new elections will probably be called for the fall, Italian bonds have fallen in price and the Euro (€) is weaker.