Europe Crisis - Italy’s “No” Vote Is Just the Beginning

By: John_Mauldin

BY ANTONIA COLIBASANU AND JACOB SHAPIRO : An important vote recently occurred in Italy. Italians said “No” to a referendum on government reforms. The vote was broadly viewed as a referendum on Prime Minister Matteo Renzi. He has since tendered his resignation.

The result of Italy’s referendum means three things. First, the slow devolution of the European Union rumbles on. Second, Italy has declared itself in open revolt internally and against the EU. This is a challenge not just for the EU, but for Germany in particular. Third, this is the beginning of a major political shift in the third largest economy in the Eurozone.

Italy will hold elections in 2017. It is unclear whether the political establishment will retain control. Parties like the Five Star Movement and Northern League advocate nationalist economic policies and a review of the EU. They could seize power. The damage already is done. Nationalist sentiment won’t go away soon.

Nationalist Momentum

This is the latest in the increasing power of European nationalist politics. Voters rejected Renzi’s proposal for reducing the Senate’s power. They opposed power transfers from regions to the central government in Rome.

By promising to resign, Renzi created major chance for nationalist parties in Italy to make their influence felt. The anti-system Five Star Movement and the Northern League turned the campaign into a rejection of the Renzi government.

Unlike Brexit, polls correctly predicted Italy’s outcome. Still, the margin was bigger than polls had predicted. A large number of Italian voters turned out to show contempt for the political establishment. The establishment erroneously believed that even if reform proposals failed, the political system would remain intact. But the opposite is happening.

Italy’s Banking Crisis

Italy is in the midst of a banking crisis. The proposed reforms to simplify decision making also attempted to fix the banking sector. Keeping investor sentiment strong is crucial. The amount of non-performing loans (NPLs) hasn’t increased in the last year and banks have started a recapitalization process to further consolidate to cut costs. But the banking sector remains fragile.

Banca Monte dei Paschi di Siena, the country’s weakest major lender, is a test case for Italy. It is the first state-backed campaign to steady the banking sector and attempt to clean up the Italian banks’ 360 billion euros ($387 billion) of NPLs. While a debt-to-equity swap that ended last Friday managed to raise 1 billion euros of the 5 billion needed, a share sale to raise more capital likely won’t be launched soon.

The banking woes are not simply an Italian problem. Italy is the third largest economy in the eurozone. Both Germany and France are exposed to troubles in the Italian banking sector. The EU and Italy have negotiated solutions for over two years, with few tangible results.

Tensions over negotiations surfaced in 2016 between Renzi and German Chancellor Angela Merkel. The referendum was not only about the Italian people’s desire for change, it also was a message that Italy won’t accept German methods or directives from Brussels on how to fix Italy’s problems. The EU and Italy are playing a game of cat and mouse over the issue of NPLs. But the referendum is a clear signal that Italians want a government that will make decisions in terms of what is best for Rome.

A Power Shift?

All eyes should now be on the Five Star Movement. It has advocated a non-binding referendum on whether Italy should remain in the eurozone. The Northern League also supports such a referendum. Populist center-right party Forza Italia may support it given its criticism of EU common currency.

A caretaker government will now take the helm from Renzi. Flexible rules for a Monte dei Paschi bailout will be decided with the European Commission. Another Band-Aid solution will be administered for the banking sector. But mistrust in the Italian economy will increase. That drives higher interest rates on sovereign debt.

The vote against Renzi was partly caused by social problems, including high unemployment following 2008. Austerity measures and slow recovery have caused increasing distance between the public and the traditional political elite. That makes room for anti-establishment and nationalistic parties to appear.

Renzi’s resignation will lead to early elections next year. It is possible the political establishment will lose that vote as well. As a result, the Five Star Movement could take power. That scenario would change the way Italian domestic politics function. It also would change the nature of ties to Brussels and Berlin.

Investors don’t lose confidence when governments change. But they do lose trust when systems change and different government rules could be implemented. The establishment’s moves are meant to reassure investors. That tactic will work for several weeks, perhaps months. But Renzi leaving is not the end of political upheaval in Italy—it is the beginning. The shockwaves will be felt in Berlin and throughout the eurozone.

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