The EU’s disciplinary strategy for Italian rebels is to rely on markets to drive up bond yields and deliver a cautionary shock, hoping that fear will shift political opinion within Italy.
It is a perilous game of chicken. The enforcement instrument is to generate stress in the banking system and it is working.
“Italy’s banks are borderline uninvestable at this juncture. In our view Italy’s markets are now in a highly unstable situation,” said Krishna Guha from Evercore ISI.
If the dosage is too high, the EU risks setting off an Italian credit crunch and a self-feeding slide into recession, detonating the very crisis that it most fears. There is no margin for error. Italy’s economy stalled in the third quarter.
When Jean-Claude Juncker lashed out this week at the Lega-Five Star insurgents and raised the spectre of a “new Greece”, he was consciously fanning the flames. It was calculated strategy.
“If the Commission president wanted a showdown between Italy and the markets, he could hardly have done better,” said Il Sole. “All it will take is a drop of petrol to set off an uncontrollable fire.”
“There are some in the EU who want to bring Italy to its knees,” said Mr Matteo Salvini, the Lega strongman. He accused a “wobbly” Mr Juncker of waging bond warfare, deliberately pushing the risk spread on 10-year Italian debt through the danger line of 300 basis points.
The precise details of Italy’s budget plans hardly matter. This is about politics. What bond vigilantes fear right now is an escalating battle between the Lega-Five Star alliance and Brussels, which - if mismanaged - threatens an Italian exit from the euro and the rupture of monetary union.
This is known among credit experts as ‘redenomination risk’. It is different from normal insolvency risk. Mediobanca says we can isolate and measure it by comparing the price moves of different vintages of credit default swaps with varying legal contracts. This component is soaring.
Brussels may be right in calculating that Rome will bend to pressure, and that the eternal ‘poteri forti’ of the Italian establishment will either bring the insurgents to heel or buy them off. But it has not happened yet.
Luigi di Maio, vice-premier and leader of the Five Star ‘Grillini’, stated on Tuesday that the government will not retreat “one millimeter” from its budget plan. “Macron and Merkel are hoping that the government will fall, but we will not surrender,” he said.
There has since been a flurry of news stories stating that the coalition has flinched and will trim the projected deficit for 2020 and 2021, but this is the familiar narrative that we have been hearing from Corriere, La Stampa, and La Repubblica for months.
What Mr di Maio in fact told the Italian parliament today is that higher economic growth will plug the gap - ie, eyewash - and that those betting on a U-turn are “deluding themselves.”
The technocrat finance minister, Giovanni Tria, who was supposed to control them, has been overruled and humiliated. Nobody will believe him again when he makes a budget pledge in Brussels.
One has a suspicion that the EU is playing from the old Greek script, or indeed the Brexit script: ratchet up the pain until they capitulate. The problems with this are obvious. Italy is a net contributor to the EU budget. It has a current account surplus of 2.8pc of GDP and a bigger manufacturing sector than France or Britain.
It has a primary budget surplus - unlike France, a serial violator of the Stability Pact - and could therefore technically switch to the lira without a fiscal crisis. Its public debt is €2.3 trillion, and it owes a further $500bn to the European Central Bank through the Target2 payments system that can be converted unilaterally into lira under Lex Monetae rules.
Even a hint that Italy might leave the euro - and either convert debts into lira or default - would set off instant contagion to Portugal, Spain, and Greece. Financial conflagration would threaten German creditors with a €1 trillion haircut.
The eurozone could head this off by making the great leap forward to fiscal union for compliant EMU members, backed by a central bank with full lender-of-last-resort powers. Germany and the Nordic ‘Hanseatic League’ have so far dug in their heels on both fronts. Nothing is in place.
The ECB will reduce its bond purchases to zero at the end of the year, leaving southern Europe exposed to market forces. The political bar to renewing QE is very high. Bail-out fatigue in Germany - where the anti-euro AfD party now chairs the budget committee - ensures an effective veto on any monetary action chiefly designed to rescue a defiant Italian government, at least until the crisis is well-advanced.
You could call this 'mutual assured destruction' except that Italy would at least enjoy some offsetting effects: a competitive edge from much needed devaluation (the REER is 20pc too high), and a fresh start from partial debt clearance. It is hard to see what the silver lining might be for Germany, Holland, or France. So who really has the upper hand?
Italy is nothing like Greece, where the pro-EU Syriza leadership badly wanted to stay in the euro. The Lega and Five Star have their roots in euroscepticism. Their fall-back plan for a ‘minibot’ parallel currency is written into the alliance’s governing contract.
If bond spreads rise to levels that choke the banking system, the government can at any time issue scrip paper as an alternative liquidity for tax purposes and contract payments, subverting monetary union from within. A two-tier exchange rate would emerge. As Yanis Varoufakis once put it, Italy would wake up one day and find that it was no longer in the euro.
Claudio Borghi, the Lega’s economics chief, told Rai Radio1 this week he was “convinced that Italy could solve the great majority of its problems with its own currency”. He described a sovereign monetary policy as a “necessary” condition for economic revival.
Mr Borghi stated that there is no plan to leave the euro and that such a move would require the consent of citizens. The message - sottinteso - is that he would welcome it if the EU pushes matters to the brink and creates this consent. Right now the EU is walking straight into his trap.
The Lega's economics guru Claudio Borghi caused a storm this week by saying Italy would master its problems better with its own currency, but this has always been his position. He wants to revive the Tuscan Florin Credit: espresso
Nor has Europe minister Paulo Savona given up his ‘Plan B’ ideas. He has published a 30-page paper on the official government website - after the Italian ambassador in Brussels refused to hand it to Mr Juncker - that starts with a quote from Machiavelli and goes on to call for soft default.
He wants debt restructuring by extending maturities and lowering bond yields to the ECB’s policy rate. “The very fact he is suggesting such a solution may well make it a self-fulfilling prophecy,” said Lorenzo Codogno from LC Macro Advisers.
Every week from now on is pregnant with danger. The rating agencies are itching to move. They might forgive fiscal loosening if the money were spent on investment that raises Italy’s economic speed limit, but not for reversing pension reform and for a universal basic income so that “Italians can go out, have a pizza, and then make love at home” - in the words of Five Star MP Massimo Baroni.
Italy’s debt dynamics are on a knife-edge. The ratio is still hovering near a record 132pc of GDP almost a decade into the ageing global expansion. The plan to abandon fiscal consolidation for the next three years leaves the country even more vulnerable to a turn in the economic and interest rate cycle.
JP Morgan says a one-notch downgrade from a single agency will trigger an exodus from Italian debt by foreign funds with portfolio restrictions. Rising rates feed through to Italian banks, which own a quarter of traded public debt and rely on the wholesale capital markets for 21pc of their funding.
Jack Allen from Capital Economics says their average maturity is four years. Each 100 point rise in yields erodes the bond value by 4pc. This eats into their tier one capital. It tightens credit.
We are back to our old friend from the eurozone crisis, the ‘doom-loop’. Sovereigns and banks can still bring each other down in a spiral effect. This is the elemental flaw of a monetary union without an automatic back-stop lender. The EU never fixed it.
Mr Juncker may succeed in browbeating Italy into submission over the next few week. But he might instead light the fire that burns down his own EU house.