The referendum may overstress the Italian political system

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On Dec. 4, Italy is holding a closely watched referendum on constitutional change which would change the balance of power between Italy’s parliamentary institutions. Prime Minister Matteo Renzi has repeatedly said that he will resign if the voters reject his proposal. The populist Five Star Movement led by Beppe Grillo, former prime minister Silvio Berlusconi’s Forza Italia, and Matteo Salvini’s nationalist Lega Nord are campaigning against the proposed change — and so are prominent personalities of the governing Democratic Party. Surveys show a strong lead in favor of “No.”

Italy’s economic outlook is poor. Forty percent of the debt held by Italy’s banks is troubled, while Italy’s central bank has liabilities of more than €350 billion, and Italy’s debt-to-GDP ratio will hit 133 percent by the end of this year. International markets are nervous — the difference between the price that Italy and Germany have to pay to raise money has risen significantly in recent weeks, although the difference is lower than it was at the height of the crisis. A “No” vote is likely to increase financial instability.

This could have international consequences

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A “No” victory followed by Renzi’s resignation could trigger market panic; bond spreads could soar and ratings agencies could follow up with successive downgrades of Italian debt in a repeat of the 2010-11 crisis. Italy is not like Ireland or Greece, as it is a member of the G7 and the eighth-largest economy in the world. This means that what happens in Italy may have substantial economic repercussions.

A panic in Italy could lead to a bank run, forcing the Italian central bank to impose capital controls as a stopgap measure. Italy’s political parties may plausibly react to this measure by clamoring for an exit from the euro zone. Italy has underperformed inside the euro zone and, as an export-led economy, it could survive or even thrive unshackled by an overvalued currency. It is not unimaginable that Italians could decide to switch back to the lira and default on part of their debt or at least impose a strict moratorium on it. The Italian debt held by foreign banks (France: €280 billion, Germany: €90 billion, Spain: €50 billion, etc.), could spread the damage much more widely, even causing an end of the euro as we know it.

What are the circumstances under which a crisis might not unfold?

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Such a crisis requires a chain of plausible events to follow one after the other. This means that it may not happen (or would unfold differently) if any of the events does not transpire. First and most obviously, it is possible that Renzi will defy the odds and win the referendum. Alternatively, he may lose but decide not to resign, thus possibly averting a political crisis at the cost of denting his own credibility. Under either of these circumstances, Italy would lurch on.

Second, it could be that even if Renzi resigned, the markets could interpret Italy’s economic fundamentals in a favorable light and keep calm as they did in the aftermath of Brexit and the U.S. presidential election. This would be especially likely if a new and reasonably stable government was quickly formed and elections postponed.

Third, if markets panicked, the German government in Berlin and/or the European Central Bank in Frankfurt could decide to change course, given Italy’s key role in Europe, and provide fiscal support to Italy. However, it would be hard for the German government to relax its fiscal stance. The populist German AfD party is threatening to outflank the ruling CDU party on the right and could use a bailout of Italy to increase support among German voters. The German Constitutional Court is skeptical of cross-border bailouts and may also intervene.

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This suggests that the European Central Bank would be more likely to act. Having launched a €1.7 trillion bond-purchase program and with a balance sheet currently at €3.5 trillion (more than a third of the euro zone’s economy), the ECB’s leverage is not limitless. It is not allowed to act as a traditional lender of last resort, but it could still intervene in the bond market by activating its “big bazooka,” the Outright Monetary Transactions (OMT) mechanism. However, this would only happen if Italy asked for it, and would likely be accompanied by harsh conditions on the loan. It is not clear that Italy would make the request — Italian voters might prefer life outside the euro to the kinds of harsh austerity that have been imposed on Greece.

Finally, market panic may finally force European leaders to reform the institutions that are destabilizing Europe. In this scenario, the euro zone states may finally restructure debts owed by weaker European countries, ‘mutualize’ debt so it could be issued by the E.U. rather than just by individual member states, force banks to clean up their balance sheets and give the European Commission a mandate to make real fiscal transfers across member states to protect against shocks and foster economic development. This would be politically hard for states such as Germany but arguably would get E.U. member states out of the institutional trap they have made for themselves.

The risks of the referendum show that Europe is unstable

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If institutions were working well, a national referendum on parliamentary politics would not create systemic international risks. The fact that the disastrous scenario outlined above is plausible shows that the current system of E.U. institutions is unstable and vulnerable to national shocks.

European elites created the euro as an incomplete structure, with the implicit understanding that its flaws would be corrected along the way. The hope was that economic integration would spur political cohesion, but the mechanism is tortuous and uncertain. As political scientists studying ‘spillover’ in the E.U. have noted, the optimistic scenario is that integration leads to political and economic fallout, thus forcing politicians to implement even more integration as a way to avert further fallout — and so on, until full integration is achieved. The obvious danger is that sometimes fallout may lead to economic and political disaster — and it is by no means certain that the E.U. will follow the path that optimists predict.