Euro Vision Contest

“You can check out any time you like, but you can never leave” – Hotel California (The Eagles).

It is time to revisit the state of the (European) union; the seemingly perpetual crisis in the Eurozone has once again caught investor’s attention as Italy is the latest to test the limits of its freedom to manage its own economic affairs. The election of a new Italian government in May this year was always going to be a test for the Eurocrats, as sentiment had definitely moved towards the Euro-skeptical, but the collapse of a major bridge in Genoa in September, with over 40 people dying led to a renewed hostility to European elites (alongside the Privately owned firm who was running the bridge), who were seen as barriers to the investment spending needed to bring the bridge’s state of repair up to scratch. The new administration rapidly promised to spend what was needed to rebuild the infrastructure of the country in general and the bridge itself in particular. But it is here that the government runs into difficulties – EU budget rules, which originally allowed a maximum deficit of 3% of GDP, now require nations to (gradually) move towards a balanced budget, which requires continual cuts in public spending at both local and national level. A sharp rise in Italian interest rates in 2011 (relative to German bunds) only increased the pressure on state finances, leaving the country in an almost permanent state of austerity and leading to the rise (and subsequent election) of the League Movement alongside Five Star, who promised to redistribute income towards those who have lost out in the previous decade. Last week they announced budget plans that involved a 2019 budget deficit of 2.4% of GDP, including proposals for a universal basic income, a flat rate of tax, reforms to the pension system as well as increased infrastructure expenditures. Although below the legally mandated 3% limit, it was perceived to be above the 2% level that the EU has deemed appropriate (and way above the 0.8% level previously agreed with the EU for 2019); the reaction was immediate- bond yields rose (and have continued to do so), Italian equities fell 3%, with the banking sector falling 6% on the news, in the process dragging down other European markets (and the Euro), prompting fears of contagion across other EU countries, such as Portugal, Spain and even French banks (all of which are currently facing “issues” in their Turkish loan books).

There was a brief respite earlier this week when the Italians agreed to (attempt to) reduce the projected budget shortfall for 2020 and 2021, but of course, a few rosy projections for growth [1] would be all that this would require (and is thus near worthless as a concession); the markets saw through this chicanery and have resumed their slide. Moodys and S&P have announced a review of the Italian Sovereign credit rating for later this month, further adding to the pressure. It is worth remembering that the blueprint for EU “negotiations” was set back in 2015 when the Greek Prime Minister Alexis Tsipras was subjected to mental waterboarding” to get him to agree to the austerity measures he himself had campaigned against in the previous election he won. Messers Salvini and Di Maio may be in for a few long nights…

The stakes are much or higher, however than with Greece, for Italy is a much bigger economy (with a debt pile to match). But it also an “insider”, a core member of the Eurozone “project”; it is thus more difficult to bully and, given its anti -EU election platform, may actually benefit from any Brussels backlash against its policies. Then again, the EU is not shy about forcing its views on a country, or even the whole bloc- the Single Currency was not voted on by the European people, nor was the successive waves of political integration – but they got it anyway. So we have an irresistible force and a (possibly) immovable object hoving into view, with competing visions of how the region should be managed. It is not clear who will win, but the loser may well be the Euro as the tensions rise. The ECB has stated that it is planning to wind down (and potentially end) their QE programme in the next year or so- so who will buy the Government debt? [2]

It all comes down to who decides on spending etc. – is it the elected government of the day or (un-elected) Brussels bureaucrats, alongside equally unelected Bond traders? If the latter duo has a veto on policy, then voting becomes pointless, which might explain Brexit, Trump’s election victory and all manner of dissatisfaction with the current political process being felt by the global populace, (it is by no means confined to Europe). It is a symptom of the increasing “, financialisation” of modern economies and governments that politicians of all stripes appear to care much more about “market reaction” to their policies than the wishes of their electorate, such that election promises get jettisoned at the first hint of a market tantrum. This also may explain why so many announcements are made late on a Friday (or over the weekend), to avoid an adverse market “tantrum” from traders. Meanwhile, the disillusion of voters and the disconnect between the rules and the governed widens inexorably. So far, citizens of Europe have broadly remained pro-EU- how much more austerity it will take for them to change their minds is an open question.

[1] According to a UBS, “Italy’s budget deficit projections have been revised down twice in the past twenty-four hours. The unreliable deficit projection expressed as a % of an unreliable GDP projection is now an unreliable deficit projection, expressed as a lower % of an unreliable GDP projection”- tweet from 4/10/18.

[2] Of course this applies across the board- once Bond traders find that the ECB backstop is no longer there, will they want to buy ANY of the issuances from EU states?