Italian equity and bond prices slipped sharply this week as a populist government took office. This chart highlights a key reason it was voted in. Inflation-adjusted disposable income per head has slipped below 1995 levels, while people in other big economies have become richer.
Before it adopted the euro in 1999, Italy was always especially inclined to inflate its way out of trouble by cutting interest rates, devaluing the lira or increasing government spending. Under the single currency the first two policies are impossible, while the third is heavily circumscribed by Brussels.
Unable to bolster the economy's potential growth with strong investment and structural reforms, Italy has slipped into an economic coma.
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Viewpoint
"Political risk is now the main driving force of financial markets. In 2017 investors... thought they had learned that political upheavals just create noise, with no lasting effect on market trends that are set by economic fundamentals. But in 2018 this relationship has been reversed. Wherever we look today at oil prices, global trade flows or conditions in Europe politics seems to overwhelm economic fundamentals and set the market trends... Will Italy crash out of the euro or cause an earth-shattering bond default? Almost certainly not. But [it] may have to suffer a Greek-style crisis to force a U-turn in populist politics similar to the one inflicted on [Greece] by the markets and the European Union a politico-economic crisis in Italy now seems like the biggest political risk facing... markets, outweighing the US-China trade [spat] or... the soaring [oil] price."
Anatole Kaletsky, Gavekal Research
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