Italy, the ECB and the eclipse of European politics.
With admirable inconsistency, the Financial Times ran a pair of stories, one berating the British Conservative party’s process for electing a new leader as being unfair because the party’s members, the only ones to vote, are not representative of the electorate at large (read pale, male and stale). The other was an effusive article by Tony Barber comparing the (unelected) departing Italian prime minister, Mario Draghi, to that legend of the Roman Republic, Cincinnatus (‘Rome will be losing premier at a perilous moment in history’, FT, 22/07/2022).
Whatever his shortcomings, Boris Johnson is an elected MP and won a general election. Mario Draghi on other hand was nominated by the Italian President to run the country in a similar way to a number of Italian prime ministers in the past decade. Winning elections or even being elected seems to be optional for prime ministers in Italy’s democracy these days. In this way, Mr Barber’s analogy to Cincinnatus is probably more apt than he would like to admit. For those whose Livy is a little hazy, Cincinnatus was twice nominated to lead Rome during periods of crisis. The title he held was that of dictator, a term which has slightly different connotations these days.
Once the crisis was over, Cincinnatus returned to his farm to plough his fields and eventually had a city in Ohio named after him. Signor Draghi leaves office with Italy in crisis, both politically and economically. Decades of meagre growth and banking crises has left the state deeply indebted - debt to GDP is over 150%.
Italy’s economy is struggling with rampant food and energy inflation, and new elections in September, which it seems may be won by a right-wing coalition of the League, the Brothers of Italy and Berlusconi’s Forza Italia, offer no prospect of stability. If anything, a less euro-centric, Draghi-free government with populist tinges which may oppose the current anti-Putin European policy stance may endanger Italy’s €200 billion EU bail out programme. This would be particularly true should Draghi’s reform efforts falter after his departure.
Needless to say, the bond market is not taking it well. Lo spread, the yield differential between the Italian and German 10-year bonds, is currently just under 2.4%, up from 1.0% a year ago (see graph below). During the Eurozone crisis, the Italian-German spread rose to over 4% amidst the political crisis which eventually saw the departure of Silvio Berlusconi as Italian Prime Minister.
It was the suspension of bond buying by the ECB under its securities markets programme (SMP) which eventually saw the bond market force Berlusconi out, his intransigence in refusing to follow Angela Merkel and Nicolas Sarkozy’s fiscal retrenchment plan proving he was beyond the pale. That series of events clearly saw the ECB take a far more political role in Europe, one which the latest ECB programme announced on Thursday 22nd July appears only to be increasing.
Aside from an apparently-hawkish 50-basis point rate hike (to 0%, despite Eurozone headline CPI inflation for June clocking 8.6%), the ECB announced a new yield-stability plan called the Transmission Protection Instrument (TPI). This crisis tool will be used to buy bonds at the discretion of the ECB governing council. It also has conditionality, including the country concerned having to comply with the EU fiscal framework, the absence of severe macro-economic imbalances, fiscal sustainability and sound government policy. On the face of it, a post-election Italy may not qualify for this, but that hasn’t stopped the ECB in the past.
The market’s immediate reactions was a jump in the euro against the dollar on the rate hike, but this was soon followed by a sell off and also a further widening in the Italian-German bond spread, perhaps indicating that the market will test the ECB’s resolve at some stage. Back in July 2012, Mario Draghi, then President of the ECB, famously said he’d do whatever it took to save the euro. It feels like the hour when that resolution is tested is nigh.
Perhaps more interesting is the appearance of the TPI when the EU already had a crisis-resolution tool in the form of outright monetary transactions (OMT). This programme would have allowed limitless bond buying as well as reconstruction loans from the European stability mechanism (ESM). The price of the OMT to the bailed-out country was always steep though - a reform programme overseen by the IMF as well as the possibility of bail-in’s with bondholders taking a haircut. In Italy, where households are heavy owners of Italian government debt, this was anathema, as was the idea of external political and economic interference. The anti-euro stance of Matteo Salvini’s League back in the 2018 elections was in part driven by this hostility to outside meddling which the OMT implied. Political extremism is always a symptom of poor policy and governance.
The market will doubtless test the ECB’s resolve over the coming months. The odds of a further ECB rate hike in September have diminished, with some suggestions that the price paid for the TPI programme was a 50-basis point rate hike in July (as opposed to a 25-basis point one) to appease the hawks on the ECB governing council. With Europe increasingly looking like it is heading into recession (despite ECB President Christine Lagarde protesting the opposite), there is a sense in the market that this might be a ‘one-and-done’ in terms of rate hikes, hence the decline in the euro. Many remember the ill-advised 2011 ECB rate hike which was soon reversed as various European bond markets subsequently started to collapse.
Yet the real price to be paid is likely political and social fragmentation. Italy is going to the polls. In France, President Macron is hamstrung by a hostile parliament. In Holland, the farmers are blocking the roads in protest against prime minister Rutte’s green policies to reduce nitrogen emissions. In Germany, the Scholz government is dealing with the prospect of an industrial collapse should gas supplies from Russia continue to dwindle. The European Commission has this past week further divided Europe between North and South with an ill-advised diktat to cut gas consumption by 15% over the winter.
Stagnation and a lack of reform have been the real legacy of the ECB’s negative interest-rate policy, and further monetization of government debt through bond purchases, particularly given the long-term inflationary impact of Europe’s catastrophic energy policy and anti-Russian stance, may serve only to weaken the euro further, a process which will only embed inflation more deeply. A pan-European crisis may mean everyone is in the same boat, but this is far from something which brings Europe together. The real question now is how the traditionally fiscally-conservative countries like Germany and Holland deal with Europe’s increasingly rapid slide into a transfer union, a process which the ECB’s TPI programme will seemingly only hasten.