Gradually then suddenly

Turning Italy's crisis into an opportunity

Asked how he went bankrupt, one of Ernest Hemingway’s characters replied: “Two ways … Gradually and then suddenly”¹.

It’s an over-used (and often misquoted) quote but there’s a reason for that: it perfectly describes what happens – to governments as well as individuals. My previous two posts on Italy’s chronic economic, political and budgetary crisis covered gradually. This last one is about suddenly, how it’s likely to play out, and the profound challenge and opportunity it will pose for Italy and the EU. To quote another American: “Never allow a good crisis go to waste. It’s an opportunity to do the things you once thought were impossible”².

Italy doesn’t have a public-debt problem, as I stressed in the first article. With stronger output and productivity growth and a sustained primary budget surplus – more revenue than spending on everything except interest on the debt – the issue would vanish. But that requires a government with a reliable majority in both houses that is willing to take on powerful lobbies in the good times and an electorate immune to populism in the bad. Short of that, a typical Italian government will eventually face the kind of test experienced by Spanish, Irish, Greek, Portuguese and Cypriot administrations a decade ago.

All of them had presided over long-standing solvency issues stemming variously from their over-sized banking systems, inflated property valuations, and leaky tax structures. All were convinced until the eleventh hour that just one more announcement or one last politically painful concession would convince their creditors. In every country, the crisis was decades in the making but the moment when the return demanded by creditors for refinancing (“rolling over”) existing government debt became prohibitively expensive was always a shock. The loss of confidence in the government’s ability or political willingness to repay debt came suddenly. Even Italy had a close call in mid-2011 when Silvio Berlusconi’s fourth and last government fell after his erratic policymaking drove Italian 10-year interest rates from 5% to 7% in the space of weeks.

Cracks in the glass

The government that takes office after the election on 25 September will be vulnerable to a repeat performance. Italy’s annual gross domestic product is €1.8 trillion and the government’s outstanding debt is €2.7 trillion. Every year, €200 billion of bonds and €100 billion of three- to 12-month bills mature and have to be refinanced and, on top of that, public spending is currently outpacing revenues by €100 billion. This means the incoming government has to raise €300-400 billion every year just to stand still.

Mario Draghi’s administration boasts that the collapse of interest rates during the Covid pandemic allowed it space to extend the average maturity of the debt beyond seven years but this is only part of the story. While seven years is the average, half of the debt is due in five. Italian 10-year rates began the year at 1% and are now over 3% yet the government has only completed half its funding programme for 2022. This time last year, it had met two-thirds of its funding needs by mid-summer. On top of that, compared to equivalent euro area sovereign borrowers, Italy issues shorter-dated securities, meaning that 35% of its outstanding debt falls due in the coming 30 months versus 25% for Spain and 20% for Portugal.

This means that higher interest rates will work their way through the stock of public-debt relatively quickly as maturing securities are rolled over. This will be offset to an extent by inflated nominal tax revenues reducing the real value of debt not indexed to inflation but markets will only be reassured over time by a sustained effort by the next government to raise Italy’s potential growth rate and run sustained primary surpluses. Superficially, the signs are good. Giorgia Meloni, the leader of nativist-conservative Fratelli d’Italia and favourite to replace Draghi as prime minister, has sent an early signal to foreign investors via Bloomberg. Apparently, “according to officials familiar with her thinking”, she “plans to stick to” the EU’s budget rules.

The trouble with this pledge is that it means nothing in practice. The EU’s stability and growth pact has been suspended since the pandemic struck and, besides, has always allowed significant political discretion. All the Italian government is being asked to do at the moment is reduce primary current public spending (unless funded by the Next Generation EU programme) and ensure fiscal offsets to energy-price inflation are phased out next year. Meloni is silent on these specifics. And then there is her right-wing alliance. In the last days of the Draghi government, Lega leader Matteo Salvini was demanding a €50-billion increase in borrowing to distribute in tax cuts. Before Draghi’s cabinet was even cold, Berlusconi – supposedly the alliance’s chief representative of moderation – was demanding a €33-billion-a-year increase in pension spending. Apart from its cost – which would be year on year and therefore structural – this is the definition of non-growth-enhancing public spending.

As she has shown since the Ukraine war began, Meloni can adapt. Who knows, maybe there is a post-fascist “Lula”³ somewhere in there, but she is also surrounded by nationalist eurosceptics. Salvini and Berlusconi have their share of those too but also responsible lieutenants who, for inexplicable reasons, have chosen to stick with the Capitano and the Cavaliere for decades.

Too big to bail

Their unwillingness to carry out meaningful reforms and their proven willingness to throw money at their bases mean the chances of a 2011-style accident are high. If it faces no choice but to accept financial support from the European Stability Mechanism (ESM), the government cannot receive full protection against the private sector. Instead of borrowing from the market, Greece, Portugal and Ireland were able to borrow cheaply and over the long term from the ESM. In return for this protection, those governments had to carry out budgetary and economic reforms - a process known in the business as “conditionality” and anathema to the Italian political class.

Italy is too big for comprehensive ESM cover - both fiscally and politically. Northern and eastern EU governments would lack the support at home to provide cheap loans to an Italian administration to cover the costs of just rolling over €300-400 billion every year. In the event of a crisis so severe that Italy lost market access altogether, the ESM could only be expected to fill the running budget deficit to fund current government operations, and co-finance a recapitalisation of a banking system wiped out by a collapse in bond prices. The rest of the cost would have to be borne by a “bail-in” – in other words, a public-debt restructuring that extended maturities and wrote off more than half the principal value of the original loans. Since more than two-thirds of Italy’s public debt is domestically held – by the central bank, commercial banks, insurance companies and households – this would amount to a massive, one-off transfer of wealth from the private to the public sector.

On the right especially, it would be fantastically unpopular and there would be plenty inside and outside the government arguing instead for Italexit. Lega economists Claudio Borghi and Alberto Bagnai are strong advocates, as was Paolo Savona – Salvini’s failed nominee for finance minister in 2018 – and Guido Crosetto, Meloni’s mentor. They – in common with papers by Hal Scott and another by Antonio Guglielmi, Marcello Minenna, Carlo Signani and Javier Suárez – would argue that swapping the euro for a new (devalued) currency would be preferable in this scenario since it would restore price competitiveness quickly and ensure creditors were repaid a fraction of their loans without holdouts.

In my view – and, I expect, the view of most Italians and their politicians if this scenario appears – the downsides of exit far outweigh the notional advantages. First, there are the unworkable practical steps to be taken that are always underestimated by advocates. As it becomes clear that redenomination is coming, the rich and the savvy middle-class spirit their wealth offshore and into other parts of the monetary union so as to maintain its euro value. The most powerful lobbies – from politicians to businesses to public-sector unions – renegotiate contracts to lock in their euro value.

Assuming (big assumption) the transition goes even moderately smoothly, do Italexiteers think the same Lombardian/Venetian small-business eurosceptics who would turn incandescent at losses on their bond holdings would be happy with a 40% devaluation of their currency? Would they be happy to see their every contract redenominated and curbs on their bank withdrawals? Devaluation and restoration of price competitiveness may appeal to working-class and left-wing voters until it dawns that this advantage soon vanishes without even more drastic and sustained supply-side reforms than Draghi promised but failed to deliver.

The cost of staying

No, when it comes to it, a solution that keeps Italy inside the euro area is the one that suits everyone best. In an attempt to pre-empt this existential crisis for the euro, policymakers have come up with blueprints to shift at least some of Italy’s debt stock onto the euro area’s balance sheet. In my opinion, the most politically feasible of these came from the German council of economic experts a decade ago in the form of a European redemption fund (ERF). In short, the idea was that member states would transfer debt worth more than 60% of GDP into the ERF and provide a dedicated tax stream to finance it until the debt matured after say 25 years. The Italians and French liked the idea in principle but not in practice (since it involved a transfer of reserves and strong conditionality) while northern states were sceptical about the willingness of successive Italian governments to sustain the tax stream. Last Christmas, Draghi and French president Emmanuel Macron gave their blessing to a proposal confined to pandemic-related debt that took a similar approach to the ERF but with one substantial difference. The debt would not be run off but rolled over and maintained indefinitely at the same proportion of GDP. This was quickly dismissed as a bid for a free ride.

Even some of the ERF’s erstwhile champions tell me I’m a Pollyanna on the subject but I remain convinced that something like their proposal will have to come true eventually. It’s the only way to combine large-scale risk mutualisation, conditionality and a joint commitment to debt reduction. But, yes, it’s already been more than ten years since the proposal and the EU – in the form of its permanent institutions and most powerful member states – still prefers to fire-fight than to pre-empt a crisis.

Ultimately, whether it’s driven by an ESM programme or to avoid one, Italy’s crisis can only be resolved by making the economy grow more quickly than the debt and/or by an injection of private wealth into the public sector. Salvini did his country no favours when he declared at the height of the 2018 crisis that "The strength of Italy, that none of the friends sitting around this table today has - neither the French nor the Spanish - is a private wealth unequalled in the world”. According to a University of Naples study, Italian household net wealth totals €8.5 trillion – nearly five times the size of the economy and three times the size of the public debt – with the wealthy holding the largest portion of their portfolios in financial assets. Over the past 20 years, the researchers found, wealthy heirs were subject to a decreasing tax burden – meaning that the share of total wealth held by the top 0.1% doubled from 5.5% to 9.3% over two decades while that of the poorest 50% fell from 11.7% to 3.5%.

How do you ask other Europeans to bail out a political economy like this? In this spirit, I’ve had a soft spot for Karsten Wendorff’s proposal⁴ for national solidarity bonds (NSBs) ever since he floated it in October 2018 to troll Salvini. Instead of lobbying the euro area for a bail-out fund, he argued, why didn’t the Italian government mobilise some of that private wealth in an act of national solidarity? The country’s 26 million households would be obliged to buy non-tradable NSBs according to their net wealth. If, for example, the "solidarity rate" was set at 20%, then a household with net wealth of €1 million would swap €200,000 in cash for NSBs. If the government continues to pay coupons on the debt, then there would be no burden on the households while any liquidity problems could be plugged by loans from banks whose own capital position would be improved by shifting their massive domestic bond exposures onto households. The burden of risk of a default would transfer from the banking system to wealthy Italians. "As voters would bear the loss in the event of default, they would have a greater self-interest in sound public finances and support such policies", he wrote.

As it would with every remedy, the right’s base would go ballistic. Not even war bonds have been mandatory although John Maynard Keynes proposed a similar idea to fund the war effort in 1940. But it is long past time for the Italian centre-left to adopt this theme. Italy needs supply-side reforms to raise its potential growth rate, substantially increase employment, and shrink the informal economy. It needs to spend more on education, digitisation and infrastructure and less on pensions. It needs efficient systems of justice and public administration, and for taxes to be collected. And it needs a big one-off wealth transfer between the private and public sectors.

Part 1: The sweet life sours.

Part 2: The lipstick walks.

1. The Sun Also Rises by Ernest Hemingway, 1926.

2. Let’s make sure this crisis doesn’t go to waste by Rahm Emanuel, Washington Post, 2020

3. Left-wing firebrand Luiz Inácio Lula da Silva (“Lula”) was elected to the Brazilian presidency in 2002 after embracing a moderate image and platform.

4. National Solidarity Bonds instead of European risk sharing: How to overcome the legacy problem of high sovereign debt in Italy by Karsten Wendorff, 2018 (available as PDF)