Italy's Five Star founder and 'guarantor' Beppe Grillo is still calling for a euro referendum and a break-up of the currency Credit: Etruria News
Prepare for a roaring economic boom in Italy. Nothing works so marvelously in the short-run as radical tax cuts and a fiscal spree worth two or three percent of GDP.
Markets have great trouble pricing political surprises. They misread Brexit even though it should have been obvious that sterling devaluation was a form of macro-economic stimulus. They misread the election of Donald Trump even though he was promising a Keynesian blitz of New Deal infrastructure and rearmament. They are now misreading the economic logic of Italy's bizarre drama.
“Austerity is over. We are going to see some rock and roll at last in this stale eurozone. I am incredibly bullish,” purred one senior Italian banker in the City. He is quietly helping the twin-headed revolution in Rome.
If you look closely, the anti-euro Lega nationalists in the new coalition are low-tax, supply-side Friedmanites, or an Italian variant of Pinochet’s Chicago boys in Chile if you prefer. What is unexpected is that the Five Star ‘Grillini’ seem to be going along with much of this, and many of them are in any case techno-utopian, libertarian anarchists.
The stimulus packs an extra punch in a country that still has plenty of slack and a negative "output gap" of 0.7pc (IMF estimate). The combined flat tax of 15pc on incomes up to €80,000 (£70,000), and 20pc for the rich, is a free marketeer’s dream. It would be no great surprise if hard-nosed Anglo-Saxon hedge funds soon become the loudest cheerleaders of the Lega-Grillini adventure.
The proposed "citizens income" of €780 a month for all is an injection of high-powered spending money directly into the veins of the retail economy, a bonanza for swaths of the depressed Mezzogiorno. Seen through this lens there is something not quite right about today’s wild sell-off of Italian bond and equities.
Investors are of course in shock. They thought Italy’s rebel twins had been tamed and that there would be no challenge to the European order or to fiscal probity. They awoke instead to read a leaked "contract for government" – albeit an old draft – that spoke of “cancelling” €250bn of Italian debt held by the European Central Bank and re-establishing “monetary sovereignty”.
The text speaks of an Article 50-style clause offering a “shared and agreed exit path” for any state that wants to leave the euro. It rips up the EU Fiscal Compact. It calls for EU treaty change on the bail-out fund (ESM) and the Stability Pact, and for political control over the Bank of Italy. It demands a drastic reversal of the "Fornero" pension reform, lowering the retirement age again by several years. The "citizens income" has not been watered down into irrelevance as previously supposed. There is to be a concordat with Vladimir Putin.
In other words, the Lega-Five Star comrades have not backed off on their original pledges after all. Five Star "guarantor" Beppe Grillo drove home the defiant message this week with fresh calls for a referendum on the single currency, and for splitting monetary union into northern and southern blocs. “It might be a good idea to have two euros,” he told Newsweek.
The coalition text is being reworked. The €250bn debt write-off is to become an accounting clause to eliminate the ECB’s €300bn holding of Italian bonds from the official debt-to-GDP tally. “It is modelled on the way the ONS treats bonds held by the Bank of England,” said Lega drafter, Claudio Borghi.
Needless to say, the ECB cannot accept such a proposal. To do so would be to admit that QE was covert ‘monetary financing’ of states in violation of the Lisbon Treaty, as German critics alleged all along. It would set off an instant challenge in the German constitutional court.
The market reaction to the bombshell leak is incoherent and likely to prove fleeting. While the risk spread on 10-year Italian debt instantly ballooned 16 basis points to 151 there was no corresponding sell-off in the debt of Portugal, Spain, France, Slovenia, et al.
Either Italy is suddenly a threat to the integrity of monetary union – in which case the entire project is in danger of unravelling – or it is not. There is no plausible scenario where Italy alone blows up while the rest of the eurozone sails calmly on. The country is too big.
"There is no plausible scenario where Italy alone blows up as the rest of the eurozone sails calmly on"
Lorenzo Codogno, former director-general of the Italian treasury and now at LC Macro Advisors, fears that the new government is now on “a Syriza-like trajectory within Europe” and heading for a disastrous showdown. “They risk losing market access. If bond spreads and bank spreads widen, Italy could face another credit crunch like 2011.”
The counter-argument is that Brussels cannot plausibly risk a confrontation with Italy. Any attempt to bully the Lega-Grillini rebels into retreat – let alone to crush them à la Grecque – risks setting off a disastrous chain of events.
The coalition would retaliate by activating its plans for a "Minibot" parallel currency that subverts the monetary control of the ECB and would rapidly call into question the political viability of the euro.
Italy does not require a bail-out. It has a current account surplus of 2.8pc of GDP and is a net contributor to the EU budget. The country is not remotely comparable to Greece.
Brussels has at last met its political match. Just as Brexit was the first referendum that the EU could not overturn (though hopes persist), Italy’s revolt is the first act of really serious defiance by a eurozone state that cannot be broken.
It would be courting fate for the EU authorities to risk an existential battle with a big EU founder-state when it is already fighting brush-fires across half of Eastern Europe, and after having already lost Britain through inflexibility, misjudgement and strategic ineptitude.
Brussels will have to put the best face on events and join the pretence that Lega-Grillini fiscal arithmetic mostly adds up. This charade can be achieved by creative use of "dynamic scoring" and penciling in a heroic fiscal multiplier.
Some €15bn to €20bn can be plucked out of thin air from a fiscal amnesty (another one). A host of tricks and "agevolazioni" are at hand, along with a putative €200bn privatization fund which sounds impressive but will never come to much. Such a smokescreen would let the EU turn a blind eye.
A messy compromise along these lines would allow the Lega-Grillini duet to go ahead with turbo-charged deficit financing. Markets are likely to let them get away with it as long as the eurozone economy holds up and the global expansion rolls on.
In a benign world, the fiscal stimulus will (ostensibly) pay for itself through higher growth. Mr Borghi argues that the debt-to-GDP ratio might actually fall faster from a peak of 133pc through the magic of the denominator effect. It is not impossible.
I have long presumed that Italy would start running into trouble when the ECB switches off its bond purchases later his year and ceases to be a buyer-of-last-resort. The country must finance debt equal to 17pc of GDP in 2019, one of the highest ratios in the world. Chronic capital flight over recent years – showing up in the Target2 liabilities of the Italian central bank – suggests that few obvious buyers are waiting to step into the breach.
Yet I am not so sure any longer. It is possible to imagine a glorious Italian summer stretching deep into 2019 and even 2020 before the music stops. The problem will come in the next global downturn.
Recession will quickly expose the deterioration in the underlying "cyclically adjusted" deficit. It will then be clear that the evisceration of the Fornero pension reform puts Italy’s long-term debt on an unsustainable and dangerous trajectory.
Bond vigilantes – capricious as ever – will awaken suddenly. By then German political consent for monetary union will have been stretched to near breaking point.
Enjoy the Prosecco for now.