Too big to fail or bail

On June 4 the American Enterprise Institute hosted a panel discussion titled “Europe’s Populist and Brexit Economic Challenge” moderated by Alex J. Pollock of the R Street Institute and featuring Lorenzi Forni (Prometeia Associazione), Vitor Gaspar (International Monetary Fund), Desmond Lachman (AEI) and Athanasios Orphanides (MIT). The panel discussion was centered around Italy’s rising populism and economic woes, with a short discussion about the possibility of a no-deal Brexit causing damage to the European economy.

Gaspar showed that only 24% Europeans polled believe in the political system at both the national level and at the European level, while 38% of people said neither works. Voter turnout in both national and European parliament elections is going down, while the share of votes going to populist parties has increased. The mainstream parties are losing votes. In 2019 there was almost a 50/50 split between votes for populist parties and those for establishment parties. With parliament more fragmented than ever, coalitions of at least 4 parties are needed to get a majority, which makes governing difficult. The 2014 and 2019 voter maps of Germany show virtually no change, while Italy’s map shifted solidly populist. “Support for populism in Western Europe is strongly correlated with exposure to the shocks of globalization,”Gaspar said. Europe needs risk-sharing mechanisms.

Orphanides sees Europe stuck between two competing narratives. The technocratic elite believes the EU has been an economic success in the past decade or two. Others think the prescriptions by the technocratic elite have not served the European population as a whole and have instead acted for the benefit of one or two member states. In the latter view, the mainstream parties of the past have to be kicked out of government and replaced by new parties that will serve the people better. 

Orphanides believes there is some truth in both narratives, but people presenting them fail to talk directly with each other, causing tension. “Europe is not a club of equals” he said, citing mismanagement of the euro crisis as the root of many present crises such as Brexit. Elites in Brussels and Frankfurt drive the agenda and have to acknowledge what has gone wrong. “Instead,” Orphanides said, “they are still in the denial phase.”

Moving on to Italy, Orphanides declared “the fact that the euro has been a disaster should be acknowledged.” Italy is a rich country and has been running a primary surplus for twenty years, so there is no reason for the Italian economy to be doing as poorly as it is. Lachman agreed a primary surplus is necessary but said the current 1% surplus is nowhere near sufficient and has to be closer to 3-4% to have a noticeable impact.

Forni disagreed, saying Italy joined the European Union because its public finances, inflation, and debt were out of control in the 1980s. You should not take averages when looking at Italy’s economy over the past twenty years. The 2008 financial crisis and the euro crisis in 2011 were damaging. Since 2013, things have gotten better and Italy has strengthened its position.

In Forni‘s view, Italian economic performance was poor because the productive structure of Italy in 1998, built on small, family-owned businesses with limited IT capabilities, was not ready for globalization. Add an aging population and brain drain, and it is easy to see why Italy suffered economically. Italy’s current debt is sustainable given no further crises the likes of 2008 or 2011, but Lachman cautioned that the Italian debt issue has to be addressed because Italy is ten times the size of Greece and bailing it out in a crisis would be a massive undertaking. “We might find ourselves in a situation in which Italy is too big to fail, but too big to bail” Lachman said. 

Forni then mentioned three things Italy needs to thrive in Europe: A debt target of 90% of GDP (Italy’s debt to GDP ratio was 132.20% in 2018), a plan of structural reforms to address issues of tax evasion and corruption, and an increase in risk-sharing at the European level. Safe assets, the European Deposit Insurance Scheme (EDIS), and an increase in labor mobility could help reduce and share risks. 

Lachman noted he was pessimistic about Europe’s future for 4 reasons: 

• Disappointing economic and political developments;
• Fundamental flaws in the euro which he doesn’t believe can be fixed;
• Major challenges in Italy and Brexit;
• The limited room for policy maneuver in Europe.

Lachman also addressed the north-south economic divide in Europe, showing that Italy’s per capita income is lower now than it was twenty years ago while Germany’s has risen. Unemployment in the southern parts of Europe remains much higher than in the north. These differences cause political resentment between the north and the south which, combined with the weakened center in EU politics and the fragmentation of parliament, make reform difficult. “The euro is fundamentally flawed,” Lachman said. “A country with low productivity like Italy cannot survive in an economic policy straitjacket with a high productivity country like Germany.” A key issue is the lack of a European fiscal union. Germany requiring a balanced budget limits its expenditures in economic downturns, while Italy’s weak banking system and unsustainable finances hold it back. 

Lachman also mentioned Germany and the US trade war. “Germany has a highly export dependent economy” and cannot afford the resulting economic slowdown and falling exports. Adding a 25% tariff on German automobiles exported to the United States would be catastrophic.

On Brexit, Orphanides said a hard Brexit would be bad for the UK and the EU, but he accuses the EU of only negotiating deals that punish the UK for leaving instead of negotiating a win-win deal. To him the only light at the end of the tunnel is the possibility of stopping the clock on Brexit to keep negotiating or a second referendum. Lachman pointed out that both candidates to take over for Theresa May have talked about the UK leaving the EU on October 31 with or without a deal.