Forget Brexit, forget Trump – the Italians have just shown us how to reject a government.
Matteo Renzi, the Italian prime minister, has lost his referendum on constitutional reform by an ego-crushingly large margin of 60% to 40%, and on a big turnout too (around 70%).
He’s following through on his decision to resign, and plans to hand in his notice to the president this afternoon.
So what happens now?
This week, it’s all about the banks
Let’s cut straight to the chase. The big issue at stake here, in the wake of Renzi’s referendum defeat, is not “Italexit” (not yet). We’ll talk about that some other time (in the next issue of MoneyWeek, in fact).
The big worry right now is the Italian banking system.
Italian banks are in a mess. They are carrying huge amounts of bad debt – far more than any other eurozone banking system. They need money. (They need to be “recapitalised”, in the jargon).
No one wants to give them that money, partly because they have too much debt in the first place, and partly because they are located inside an economy that has gone nowhere for about 20 years (which by no coincidence, is roughly the same length of time that Italy has been part of the single currency).
Now, in the grand scheme of things, the amount of money needed by Italian banks is not that great. We’re talking tens of billions rather than trillions. While that might be a lot of money to you or me, when you can print money to order, it’s a rounding error. In most countries, the government (backed by the central bank) would step in and bail them out (just as we have in the UK).
Everyone would complain about it, and you’d store up lots of unintended consequences for the future (just as we have in the UK), but the immediate problem could be solved easily.
But this isn’t “most countries”. This is the eurozone. And countries in the eurozone – as they have rapidly found out since the financial crisis – lack many options that are open to countries with their own currency.
This year, the eurozone authorities effectively made it illegal to bail out your own country’s banks. Instead, you have to force bondholders to take the losses.
That sounds like a good idea, until you get to the practicalities. In the UK, bank bonds are typically held by the big institutions. Generally, those individuals who hold them have a pretty sophisticated understanding of how they work.
But in Italy, many ordinary Italian savers have effectively been mis-sold Italian bank bonds as equivalent to a high-interest savings account. If they lose their savings, you have a riot on your hands.
The Italian government under Renzi was groping towards a solution to the banks. Either he’d have told the European authorities where to go, or they’d have come to some sort of fudged agreement. The point is, the government was working on a plan.
But now Renzi is resigning. That throws doubt on all the bailout plans and fudge and any other hopes and schemes that had been hatched up.
No surprise that Italian banks were among the biggest casualties of the vote as the markets opened this morning.
The canary in the bank vault
The biggest threat specifically is to the world’s oldest surviving bank, Monte dei Paschi di Siena. The bank was meant to be raising €5bn by the end of the year from private investors. The risk is that this result makes that harder to do.
The Italian president has 70 days in which to try to form a government. Assuming that he can do that, fresh elections aren’t required until 2018.
But there’s no doubt that this “no” vote increases political uncertainty in Italy. And do you really want to invest in a sickly bank that’s bound to become a political plaything against that sort of backdrop?
You might think not. But so far, judging by the follow-on market reaction this morning, the answer is “well, yes”. A bit like what happened after the Donald Trump victory, markets are rebounding rapidly from an initial sell-off.
There are a few reasons for this. Firstly, the “no” vote wasn’t exactly a surprise. In fact, “yes” would have been a much bigger shock. So markets were hardly unprepared for this event.
Secondly – despite its characterisation by some as being a revolt against the ruling class, the Italian “no” vote is in many ways a vote for “business as usual”, as Fathom Consulting points out. Weirdly enough, in the long run, this lack of reform makes it harder in some ways for Italy to leave the euro, because any future anti-EU government would still have to wrestle with the Italian upper house.
But most importantly, it’s all down to faith in the European Central Bank. The ECB has been hinting that it would buy Italian government bonds if things looked a bit sticky, and as is always the case when central banks promise to print money, the markets are getting excited about that. It’s a big bet on the usual dollop of “eurofudge” to smooth things over.
Are markets right to be this sanguine?
I said last week that the Italian referendum was probably a “sell the lead-up, buy the result” event. So far it looks as though that was correct.
However, just because markets can be predictable sometimes, doesn’t mean they’re right.
The banks are a gaping hole that can be plastered over, that much is true. We all know how flexible eurozone rules can be when they’re in trouble. But there’s no guarantee that we won’t have to see another big panic before it gets to that point.
Moreover, in the longer run, this “no” vote means Italy is no closer to dealing with its problems. The fundamental issue here is that the country can’t grow fast enough to resolve its debt burdens. That will now continue to eat away at social support for the status quo.
In the longer run, that can only make it more likely that a party such as the Five Star Movement gets into power. That might not lead to an Italian eurozone exit immediately – but other citizens in the eurozone might not appreciate the idea of risking their taxes being used to prop up such a vast, unhealthy economy.
My colleague Tim Price has been writing about the fragility of the Italian banking system – and its potential knock-on effect to the rest of Europe – for a good few months now. But if you want to know what the worst-case scenario could bring, I suggest you check out Tim’s views here.