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Everybody’s worried about populism these days.
Populism currently means all politicians who diverge from the sort-of-centrist consensus that built up during the 1990s, dominated the 2000s, and then has been chipped away at since the financial crisis in 2008.
Europe has just seen one of its biggest victories for populism yet.
Italy is now on the road to being led by not one, but two radical parties.
So what does that mean for markets?
So far, not an awful lot, it turns out.
Why markets don’t care about Italy – yet
Italy’s Five Star Movement and its League party have decided to join forces to govern Italy. They haven’t quite figured out who’ll be prime minister yet, but they seem to be well on the way to teaming up in order to avoid another general election.
This is an intriguing combination. Five Star is “eclectic”, as The Wall Street Journal tactfully puts it. It is hard to pigeon hole. It wants higher government spending, but also lower taxes. It flip-flops on lots of other issues. The League, on the other hand, is a right wing, anti-immigration party.
They are by no means entirely incompatible, but until recently, you wouldn’t have expected them to be partners. Yet they have decided to put what differences they might have aside in favour of forming Italy’s next government.
Given the panic caused by the prospect of populists in France (remember when Marine Le Pen was the great fearsome cloud hanging over markets?), many commentators have remarked on how odd it is that markets frankly don’t seem to give much of a monkeys about what’s happening in Italy right now.
That seems odd at first sight. After all, both of these parties have at times in the past expressed strongly eurosceptic views. They’re also continuing to chafe at the European Union’s rules on budget deficits, and what they see as EU-imposed austerity. They want to spend more regardless.
However, the reason markets are currently unruffled is pretty straightforward: Italy is a huge economy, but in terms of market influence, it’s not that important in the grand scheme of things.
Investors care about two things: will Italy go bust and will it tear down the euro? For now, the answer to both of those questions is “no, not for a while yet”.
Firstly, the European Central Bank (ECB) is still buying government debt, a lot of which is Italian. So that puts a cap on yields. Over and above that, Italy has managed to extend the maturity on its debt over the last few years, so it has more breathing space than it did at one point.
Secondly, as Jack Allen of Capital Economics points out, while both parties “have in the past suggested leaving the euro” neither one is currently campaigning for an exit. And with good reason – the reality is that most Italians still support euro membership.
If populists have learned anything from Greece (or should have learned anything), it’s that most people – eurosceptic or not – will not vote for a policy that runs the risk of devaluing their savings by 50% or more overnight.
So that, in a nutshell, is why the markets aren’t particularly bothered about Italy. The ECB is propping it up, and it’s not agitating to leave the euro. The status quo, at a big picture level, is safe.
How long can this last?
Clearly, the next question is: will this state of affairs last? That’s a different story.
Italy is heavily indebted. That’s because its economy isn’t growing. As someone pointed out the other day (I forget who, apologies if it was you), France has been a lot more profligate than Italy in terms of public spending over the last few decades, but it’s in better shape because the French economy has also grown.
So the solution to Italy’s problems is serious structural reform. But that’s hard. It’s also political – it’s something that a population has to vote for. It can’t be seen to be being imposed from without or people rebel (which is what happened in Greece).
This is where the euro makes life difficult: if you can’t be bothered to reform your economy, then you devalue instead. That is – to be clear – not a solution to a country’s problems. But it does, in effect, allow it to continue to run things in its own inefficient haphazard way.
Now devaluation is no longer an option. And this, really, is where Italy is banging heads with the EU. Again, back in the day, this didn’t matter much – the EU’s deficit rules are hard to take seriously given that pretty much every country as broken them at one point or another.
But that was back when markets weren’t picky. Before the financial crisis, one eurozone bond was as good as another. They were all Germany, because Germany was expected to pick up the bill if any of them went bust.
The financial crisis – and the collapse of the banking sector in several countries – tested that theory to breaking point. That’s what we saw with Greece. And the end result is that markets turned out to be half-right. The ECB got its way and printed money to bail out countries and their banking sectors, but only after a lot of pain and the odd haircut for creditors.
So, to cut a long story short, this whole situation will start getting difficult again when the following things happen.
One, the ECB stops printing money (quantitative easing, or QE). That’s when the tide will rush out on the countries that are still swimming naked, as it were. The main flashpoint here – I suspect – will be when Mario Draghi comes closer to stepping down next year.
Secondly, problems could arise more rapidly depending on just how aggressively the coalition of populists decides to challenge the EU rules on spending. I suspect this won’t happen until the withdrawal of QE – so the two issues will blow up together.
In short, Italy isn’t this year’s problem. But it could well end up dominating headlines next year.