From Acropolis Now to Arrivederci Roma – get ready for the next big euro panic

Luigi Di Maio and Giuseppe Conte © Getty Images
Luigi Di Maio and Giuseppe Conte: sticking two fingers up to the EU

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It’s still looking a bit messy out there.

I suspect it’s going to get messier.

There are lots of reasons for markets to be nervy. Rising interest rates are the main structural issue. But rising rates in themselves don’t need to be a disaster.

For me, the real clincher here is Italy.

Markets are way too complacent about Italy

I’m not a eurozone permabear – I think the euro was a mistake, but I’m not passionate about that. It’s not up to me what currency people want to use. And in 2012, when everyone thought the eurozone was about to disintegrate, I recommended piling in to the region’s stockmarkets. There was just too much gloom around.

But right now, I think markets are way too relaxed about Italy. No doubt, there is a long-term solution. But I cannot see how we avoid having some short-to-medium-term, Greece-style turbulence before then.

The problem is that markets have been lulled into complacency by the idea that central bankers can fix anything. And that has been a good working assumption for the past nine years or so.

But as with all such overarching theories, it only works to a point. We’re now reaching that point.

Central bankers can paper over a lot of problems. That’s what European Central Bank (ECB) boss Mario Draghi has done (and he’s done it well, to be fair to him). But “whatever it takes” was always going to be a temporary solution.

What really happened in 2012 (and the subsequent years) was a political deal. Europe’s leaders don’t want the euro to fail, as that would be pretty catastrophic economically (maybe not in the long run, but definitely in the short run, which is a politician’s time horizon).

However, nor do the Germans want to pay for the Greeks or the Italians to enjoy lower retirement ages and less-than-thorough tax collection policies than they themselves have to put up with. (Whether this perception is fair or true or not, is irrelevant. This is politics. Perception is all that matters.)

So via a long, painful process of trial, error, and emergency summits, the eurozone’s leaders reached a deal. The so-called Club Med countries agreed to rein in their perceived profligacy. In return, the so-called northern countries (mostly Germany), gave the nod to the ECB to prop up those countries with money printing.

Of course, there is also the fact that the banking systems of the northern nations are hopelessly entwined with those of the rest of Europe, but let’s park that. It’s an underlying hypocrisy about the whole thing, but it doesn’t affect the basic argument.

So let’s just reiterate this, as it’s at the core of why Italy is now a serious problem: the ECB’s money printing has been the mechanism which has kept the eurozone together in recent years. But that has been contingent on the likes of Spain, Greece and Italy reining in spending and making noises about reforming their economies.

Italy, with its new budget, has now stuck two fingers up to that deal. That in turn means that the deal has to be renegotiated. We’re seeing the warning shots being fired right now.

Yesterday the European Commission warned Italy that its plans to spend more money rather than cut back represented “particularly serious non-compliance” with European Union fiscal rules. They want Italy’s government to explain itself by midday in Monday. And if they can’t hammer it out over the following week, Italy will be asked to rewrite its budget.

Arrivederci Roma? Probably not, but even asking the question will scare markets

As we all know only too well by now, these sorts of deals are not arrived at through calm and considered discussion. Instead, they are reached through a process of brinksmanship, whereby each side pushes the other to recognise what they have to lose.

With Greece, the eurozone just needed to buy time for French, German and other banks to ditch their exposure to Greek bonds. At that point, Greece was effectively delivered an ultimatum: suck it up, or leave the eurozone. They chose – reluctantly – to suck it up.

Italy, on the other hand, is the world’s third-biggest issuer of sovereign debt. Financial quarantine is not an option. So you’d expect the negotiations to be correspondingly harder.

This is not to say that Italy is going to end up leaving the eurozone, or destroying the euro. But it’s going to be a tense few months at least, and it’ll probably take longer than that.

The ECB will be hoping that rising borrowing costs for Italy will bring the government back to the negotiating table. Italian borrowing costs are now at a four-and-a-half-year high. The gap between Italian and German ten-year government bond yields is at its highest since 2013.

Yet there’s only so far the ECB can let yields stretch before investors start to worry about the euro itself being able to survive. If there’s one thing the ECB has said that it can’t allow, it’s for that doubt to creep in.

So unfortunately, even although we’ve already been through this once with Greece, I’m not sure that the earlier experience is going to make this one any easier. When markets wake up to that – along with all the other problems out there – they’re not going to like it.

I’ve talked more about how to prepare your portfolio in the current issue of MoneyWeek magazine, out today. If you’re not already a subscriber, sign up now. (I would suggest that now is a particularly good time to do so – I know I would say that, but even so, it’s true.)