Lorenzo Codogno argues that the economic and financial crisis that started more than ten years ago was not only devastating for the Italian economy, but also jeopardised a key mechanism for achieving political consensus. Brussels’ role as an external anchor for economic policies that are in the common interest but are socially and politically difficult to accept and implement has been undermined. Europe’s governance and fiscal framework are paper tigers, while the discipline imposed by financial markets is even more effective than in the past, but is imperfect, inefficient and risky. Ultimately, it may sanction the failure of European governance, as well as that of the national economic policies that started the new crisis.

The actions of Italy’s government appear to suggest that it views political and social sustainability as being more important than budgetary sustainability. In fact, in a democracy, what the citizens want counts, and the latest Italian elections rewarded those political forces that had openly criticised austerity policies. However, the harsh law of numbers is not an opinion. Nor is it a question that can easily be delegated to voters.

Politics must play within financial constraints. This is what Article 81 of the Italian Constitution and European rules say, and implicitly also financial markets. In the past, there was the so-called ‘external constraint’, which allowed Italy to make significant economic and financial progress. The pressure from Brussels for structural reforms and a disciplined fiscal policy used to translate into a lever to make decisions that would otherwise have been more difficult for the government and parliament. This was a way to indicate policy objectives that were in the general interest of the country, even if they were politically and socially hard to accept and implement.

It also served to counterbalance the short-term interests of some politicians. It was, in fact, the way to solve the dilemma indicated by Jean-Claude Juncker: “We all know what to do, we simply do not know how to be re-elected after having done it”. The tendency of politicians to follow the path of least resistance, following the electoral mood, was counterbalanced by European constraints that had to be respected, albeit reluctantly, shifting the responsibility to Europe. All of this was particularly true during the convergence phase that preceded entry into the monetary union, and immediately after that. The collective benefit of European integration and the well-being that it promised to bring was such a strong argument for voters that even the politicians most tied to particular short-term interests had to consider it.

Now it seems that the roles have turned upside down. The economic crisis that began in 2007, and especially the 2011 debt crisis, changed this mechanism. There was no full ownership of budgetary discipline and structural reforms in the past, and thus they were immediately put into question. The 2011 crisis was not only devastating for the Italian economy, but it also jeopardised the mechanism for achieving political consensus and the role played by Brussels, which until then had more or less worked.

Fiscal rules, and more generally European governance, are now viewed with suspicion, if not with open hostility. They are no longer a virtuous link but the enemy to be defeated to save the national interest. What is defined as “austerity”, and the sometimes rigid and complex set of rules and procedures that characterises European governance, is increasingly seen as an unfair imposition of an economic recipe judged to be bankrupt. Brussels institutions and rules are perceived as abstract entities that impose unpopular and socially harmful measures. Furthermore, Europe’s success is questioned, and Italy’s significant economic underperformance is attributed to Europe itself and the euro. Brussels is often taken as synonymous with distant and non-legitimate bureaucracy. In the populist vulgate, it is the symbol of the elite against the people.

European governance, with all its complex and articulated procedures, is effectively a paper tiger. It works to the extent that everyone believes and recognises it. However, if a government deliberately contravenes the rules, European governance is weak in facing opposing popular will, despite all the Treaties and the legal bases supporting it. Although the Commission is a political entity, elected by the European Parliament, which in turn is elected by the citizens, it is still too far away. Legitimacy and authority of the European institutions are not yet fully recognised, and therefore, without an acceleration towards full fiscal and political integration, governance tends to show all its limits.

These difficulties became evident in the tricky negotiations between Italy and the European Commission on the Budget Law. Europe is still weak, as is its political legitimacy. It must inevitably leverage on complex procedures and regulatory frameworks that ultimately have only one objective: channelling national economic policy choices towards common goals, but without having the democratic powers and tools for imposing them. On the European side, it is increasingly clear that it is challenging to design mechanisms and procedures that are shared and produce the desired results, i.e. favouring sustainable budget policies and allowing them to play their full countercyclical stabilisation role. Furthermore, it is increasingly difficult to have effective and transparent procedures that are also perceived as entirely legitimate.

In this context of an incomplete union, the reaction of other European countries is not to push towards “more Europe”, but is almost a sense of dizziness and rejection. The crisis has left scars in the relations among European Union member states, especially those of the euro area. They show a sense of mutual distrust that is, de facto, blocking any initiative towards further integration and sharing of policies and common institutions. Indeed, it seems that the recently-undertaken initiatives are mainly aimed at ring-fencing Italy to prevent the rest of Europe from being affected by its problems.

Italian Prime Minister Giuseppe Conte at the meeting of the European Council in December 2018, Credit: © European Union

Initiatives that could hurt Italy in the future were approved in December, with the blessing of the Italian government and the almost total silence of the media. It was known that Italy was too large to be helped by other European countries. Equally, it was recognised that the other European countries would have demanded a full programme for Italy (i.e. the so-called Troika), before any aid or funding, including the possible use of the ECB’s Outright Monetary Transactions (OMTs). However, the decisions in December made it clear what many suspected, namely that other European countries are preparing for Italy’s default.

In the December summit, European leaders proposed a reform of the European Stability Mechanism (ESM) Treaty. They introduced precautionary funding lines, without conditionality, for countries that fully comply with European fiscal rules. These are the so-called “innocent bystanders”, those countries like Ireland that could be affected by the financial contagion stemming from Italy. Another type of financial assistance, with limited conditionality that could have been of help to Italy in case of need, did not pass. Also, a technical change that facilitates debt restructuring with private creditors (single-limb CAC) was approved. Finally, and perhaps most importantly, it passed the principle that before any financial assistance the country’s debt must be declared sustainable by the ESM and the European Commission.

Besides, expectations on the introduction of a modest and symbolic European budget were disappointed. In a more or less explicit way, all this means that if Italy loses market access and asks for European financial assistance, it would be required to first restructure its public debt, even before starting any discussion. Therefore, the Italian government should explain to Italian citizens what would happen if budget discipline and confidence in financial markets were to disappear completely. In this vacuum and lack of effectiveness of European rules and institutions, the most stringent constraint remains the one imposed by financial markets. If European fiscal governance is a paper tiger, financial markets are not.

It may have been a coincidence, but the government’s attitude towards the Budget Law changed when the outcome of November’s BTP Italia auction was disappointing. This event made the government understand that it could not count on Italian savers to replace the diminished interest of foreign investors. Even Italian investors tend to reduce their exposure to government bonds. Nor can the government count on banks and other resident financial institutions, which are grappling with stringent financial and regulatory constraints. Even the system of European central banks is no longer able to contribute. Its net purchases, which had guaranteed almost full financing of Italy’s borrowing requirement in the last 3-4 years, have gone to zero since January. So who is going to buy Italian government bonds? If the government preserves what is left of Italy’s credibility and budgetary discipline, then it will continue to have access to financial markets. Otherwise, the impervious road to public debt restructuring would open up.

The external constraint of financial markets is a deadly mechanism. In a monetary union, it is no longer possible to use monetary and exchange rate policies to absorb each country’s specific economic and financial shocks. In the absence of financial instruments that allow mutualisation of the risks on public debt (various possible forms of eurobonds and European fiscal capacity), even a modest shock risks turning into a tightening of the country’s domestic financial conditions, further worsening pro-cyclically the developments in the real economy.

The overall stance of the current Italian government and the economic policies introduced so far have led to a widening of the yield spreads between Italian and German government bonds and some capital outflows. Also, they have produced a decline in business confidence, which projects a sharp fall in investment in the near term. However, the tensions in financial markets tend to be transmitted to the economy mainly through the credit channel, with a tightening of the supply of credit and an increase in the cost of borrowing. Signs to that effect have already materialised, despite the apparent calm of financial markets since the beginning of this year. In a monetary union, these effects tend to amplify the financial shock for the country that does not respect the rules and is at risk of sustainability, well beyond the increase in public debt servicing costs.

The discipline imposed by financial markets is still effective. Indeed, it is even more so than in the past. However, it is an imperfect, inefficient and risky constraint. Its ultimate consequences would sanction the failure of European governance, as well as that of the national economic policies that started the new crisis.

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Note: A slightly longer and different version of this article first appeared, in Italian, in Aspenia no. 84 “La battaglia d’Europa”, March 2019, www.aspeninstitute.it. This article gives the views of the author, not the position of EUROPP – European Politics and Policy or the London School of Economics.


About the author

Lorenzo Codogno – LSE, European Institute
Lorenzo Codogno is Visiting Professor in Practice at the LSE’s European Institute and founder and chief economist of his own consulting vehicle, LC Macro Advisors Ltd. Prior to joining LSE, Lorenzo Codogno was chief economist and director general at the Treasury Department of the Italian Ministry of Economy and Finance (May 2006-February 2015). Throughout this period, he was head of the Italian delegation at the Economic Policy Committee of the European Union, which he chaired from Jan 2010 to Dec 2011, thus attending Ecofin/Eurogroup meetings with Ministers. He joined the Ministry from Bank of America where he had worked over the previous 11 years. He was managing director, senior economist and co-head of European Economics based in London. Before that, he worked at the research department of Unicredit in Milan.

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