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Financial markets gripped by political rather than economic developments

What does rising populism mean for the future of Italy, the European Economic Union and global markets?

Central banks addressed the credit crisis by printing vast amounts of money (quantitative easing) and keeping interest rates at 0% or below for a long time. This strategy was intended to accelerate economic growth and boost employment by promoting more corporate borrowing. This would cause unemployment levels to fall and wages to increase, allowing consumers to spend more without having to borrow.

A decade on, the US has nearly realised this objective and Europe is close as well. However, at the same time, concerns around deflation are shifting to concerns about inflation. If inflation occurs, economic growth will have to be pushed back to potential growth (potential growth is the sum of the increase in the workforce and productivity growth). Otherwise, inflation and/or trade deficits will rise.

Presently, potential growth is at 1.75% in the US. Hence, it is quite odd that the US economy receives fiscal stimulus – as this boosts growth to 3%. Incidentally, potential growth in Europe and Japan is not much higher than 1% and 0.5% respectively.

A substantial increase in the potential growth rate requires far more investment in areas that improve competitiveness. However, the question is where the governments will source the necessary funds, as most governments have maximised borrowings.

How about printing additional money? This is not an option once concerns about deflation shift to concerns about inflation. In other words, cutbacks on social security would be required – expenditure on social security has been driven up to ever higher levels in order to absorb/obscure the loss of competitiveness. However, it is virtually impossible to find a political majority for this anywhere.

Fertile soil for populism

This situation creates an ideal breeding ground for populists. Indeed, since the credit crisis and the introduction of increased competition, globalisation and modern technology, the personal situation of half of the world’s population has barely improved. The top layer, on the other hand, has certainly seen an increase in incomes and the value of assets they hold. This brought Trump to power in the US. He promised lower taxes for everyone as well as economic stimulus to the extent where the labour market would tighten to the point where everyone would enjoy wage increases. Trump promised he would create a climate conducive to corporate investment, resulting in productivity growth.

However, he overlooked the fact that the Fed would not tolerate growth exceeding potential for a long period of time. Furthermore, he had a simple solution to excessive foreign competition: raising import tariffs and forcing other countries to lower theirs. Whilst this strategy may improve the US trade balance, the potentially positive effect on US exports will soon be cancelled out by a higher dollar exchange rate. Moreover, higher import tariffs will result in higher consumer prices.

Chart 1: More spending on education is needed in the US to stimulate productivity and economic growth
Chart 1: More spending on education is needed in the US to stimulate productivity and economic growth

Source: Thomson Reuters Datastream/ECR Research

Italy likely to get the upper hand

In Europe, the appeal of populist solutions has also increased, resulting in Brexit and the swelling popularity of populist parties across the continent. However, there is a major difference for European Monetary Union (EMU) countries: central banks in the US and the UK are able to absorb heavy blows. This is also possible in Europe provided most countries move in the same direction.

Italy is a case in point. Italy has an outdated legal, social and economic system. In addition, it has a complex political structure, born out of efforts to prevent a figure like Mussolini from ever rising to power again. The end result is that Italy has lagged behind most other European countries for decades. The lira was always being an important lightning conductor, and the currency was devalued many times. However, after the introduction of the euro this was no longer possible.

The rise of international competition has therefore resulted in stagnating or declining incomes among large groups of the population. In addition, public finances have been deteriorating for a long time, to the extent where it is not possible to borrow much more.

This means that any additional borrowing should come from the private sector. The central bank is supposed to stimulate this. However, this is not possible in the current circumstances because the ECB focuses on the average of the EMU countries. It should actually tighten its policy based on the average. The fiscal route is therefore the only remaining option, but this would only be possible if Italy were to violate the Maastricht rules.

Wishful economic thinking

The two major populist parties in Italy that have formed a new government have stated they want to increase public spending and lower taxes but have no intention of leaving the EMU. Although their fiscal plans will, according to many economists, breach the Maastricht rules, Lega and the Five Star Movement (M5S) expect higher economic growth will increase tax revenues to such an extent that the budget deficits will remain below 3%. This reasoning is very similar to that of the Trump administration.

In other words, we will be dealing with an Italy that wants to stay in the EMU, but which does not want to comply with the associated rules. As there are no rules in place to oust a country from the EMU, the question is how the other EMU countries will react to the developments in Italy. We assume they will accept a great deal for the time being because a European crisis and the collapse of the EMU would entail far greater drawbacks.

At a time when China is on the rise, Russia is becoming more aggressive and the US wants to leave Europe to its own devices, Europe will have to stick together if it is to amount to anything on the world stage. If necessary, the stronger countries will simply have to foot the bill.

This situation carries the following major risks:

  • Europe reaches the point at which concerns about deflation shift to concerns about inflation. In this case, European economic growth would have to be pushed back to approximately 1%. In this scenario, the soaring debts and massive public deficits would be increasingly difficult to sustain.

  • It cannot be ruled out that Italy’s policy will be adopted by other European countries – not that this policy will provide any solution in the long run, but it is initially very appealing to large sections of the population.

Market coercion?

An important question remains: will the markets force Italy back in line? We believe the ECB will continue to gear its policy towards the average of the EMU countries and not towards that of Italy. This average will not change due to problems in Italy, as rising tensions will push down interest rates in the stronger EMU countries and weaken the euro.

This will boost growth in the stronger EMU countries. Consequently, Germany and the other stronger EMU countries would actually require higher interest rates in this case. This is why we ultimately do not expect the ECB to come to Italy’s rescue to any great extent, all the more so because the majority of ECB members are quite willing to impose sanctions on Italy for violating the rules.

This brings us back to the question as to whether or not the markets will bring Italy back in line. Indeed, it is not nice to have to pay a higher interest rate in a situation where the public debt is 130% of GDP. The higher interest rates will also affect Italian economic growth. We believe this will indeed be the reason why Italy will have to make concessions in the long run. However, we do not see this happening any time soon:

  • A large proportion of Italian government bonds are held domestically. In addition, the average term to maturity of the public debt is approximately seven years. As a result, rising interest rates are not immediately tangible.

  • The populists use this as an argument to say that the rules from Brussels should be amended rather than their policy. This reasoning appeals to many Italians for the time being. The market movements only make the Italians more militant for now.

We think tensions in the EMU will increase in the coming months and these tensions will not be easily addressed, as the causes are rooted in developments in the last decades. Other Western economies are, or will be, affected by this too, but the biggest problems will likely occur in the EMU due to the lack of flexibility the ECB has in addressing problems in one country. Despite some very sound fundamentals of the EMU (lower government deficits and a positive trade balance), the euro will be under downward pressure in the coming quarters.