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Italy Heads for Confrontation with Itself, Financial Markets, and Europe



President Sergio Mattarella has put Italy on a path of political confrontation domestically and most likely with financial markets and the rest of Europe.

By vetoing the candidate for finance minister insisted on by Italy's majority coalition between the nationalist, anti-immigrant, and anti-Europe League (formerly the Lega Nord) and Five Star Movement (MS5) parties—over objections to his past support for an Italian exit from the euro (even organized in secret)—and instead appointing  an Italian former IMF official as prime minister well known for opposing their policies, Mattarella has dared his country's new political leaders into forcing an early election fought largely on the issue of Italy's euro membership. By refusing to propose a compromise candidate for finance minister, the League and MS5 parties have evidently embraced confrontation.

President Mattarella did not explicitly rule out his country's departure from the euro.  But he demanded that such a monumental decision be taken after an open debate, preferably as the center of a new election campaign. His action served as an open invitation to financial markets to exert pressure on Italian voters before they next cast their ballots. In contrast to the Brexit referendum in the United Kingdom, negative economic consequences would weigh on Italian voters as they go to the ballot box again, as the president's action is a recipe for serious financial volatility in Italy in the coming months. Rational investors will seriously reprice, and some will flee, Italian assets, in response to leading politicians advocating a departure from the common currency.

Europe has been down this path before—in Greece in the summer of 2015. But it is unlikely that Mattarella will get his wish that Italy's next election will be fought over whether to stay in the euro or not. Opinion polls suggest that most Italians support the common currency, implying that they would vote for parties favoring to remain in the euro. But just as Prime Minister Alexis Tsipras denied he was against the euro in the July 5, 2015 referendum on whether Greece should accept the Troika bailout conditions or not, the leaders of Italy's two main parties, Matteo Salvini of the League and Luigi Di Maio of MS5, will say that they also don't oppose Italian membership of the euro. Instead, they will likely frame another Italian election campaign as being about "standing up to Germany/Brussels" in support of Italian sovereignty and Italian ability to run its own fiscal and economic affairs. They may succeed in that approach and win just as they did in March this year.  An important difference between Greece then and Italy today, however, is that in the summer of 2015 only Greek prime minister Tsipras needed to respond to the euro area's economic pressure, but in Italy now voters will need to do so when casting their ballots in a new election. This situation is far more uncertain.

Another win for the two parties would be dangerous. Whatever the League and MS5 leaders say in the campaign, a victory by their parties would secure a majority for economic policies that are incompatible with membership of the euro and would be justly interpreted in the rest of the euro area as a signal that "Italians want to leave" the common currency—just as in Greece after the July 2015 referendum. An Italian exit from the euro, once considered impossible, would no longer be unthinkable. Redenomination risk in Italy would still be very small, but it would be a real.

It is worth recalling, for example, that in late June 2015 in Greece, Tsipras's decision to abandon the negotiations with the country's creditor representatives and call a referendum on the bailout resulted in the European Central Bank (ECB) cutting off liquidity to Greek banks. As a result, capital controls were imposed in Greece.  Italy is not Greece and this is not 2015, but a similar crisis scenario, including the need to impose capital controls, would not be inconceivable in Italy if populists win the election later this year.

For both sides, the key issue will be to frame the narrative around another election. If Mattarella succeeds in making it about euro membership, more mainstream parties may stage a comeback, possibly forming a coalition with one of the two main populist parties. After all, until recently, the prospects of MS5 linking up with the mainstream center-left Democratic Party were real. For the worst scenario to unfold in Italy, the League party would have to win over 40 percent of the vote, and under Italy's election law thereby an absolute majority in parliament, on its own.

Another election invites unpredictable events, however. Most damaging, if 30,000 new refugees were to arrive from Libya in coming months, League's anti-immigrant cause could be strengthened. And lectures from EU politicians, especially Germans, about staying in the euro area could backfire and fuel populist anger in Italy. Europe should therefore help by shutting up in the coming months. And then there is the question of who will be the leader of a mainstream pro-Europe platform in Italy in a new election. Former prime ministers Silvio Berlusconi and Matteo Renzi of the center-right and center-left, respectively, are both deeply flawed candidates, but obvious alternatives are yet to materialize.

And while it is not tenable for Europe, and especially the ECB, which will be walking a legal tightrope with an Italian president in his last term in office, to openly try to accommodate Italy's populists and their demands, the rest of EU and euro area members can help stabilize the political situation in Italy in the short run.

Germany will invariably be blamed for many of Italy's economic problems during another election campaign, though this would be unfair as most of Italy's economic ills have deep domestic roots that predate the introduction of the euro. Germany's failure, however, to use its leadership in Europe to push a more ambitious European external border control project forward since 2015 has been a serious political mistake. Its initial open door policy in 2015–16 convinced many would-be migrants to risk crossing the Mediterranean into Europe. Being a major port of entry for migrants, Italy has had to bear a disproportionate burden of refugees due to its geographic position. It thus legitimately feels abandoned by Germany and the rest of Europe, especially in light of Germany's push for the EU refugee deal with Turkish president Recep Tayyip Erdogan in 2016.

The best idea for Germany, Italy, and Europe would be if in June EU leaders shifted gears and scaled up common European border control and refugee acceptance, devoting more resources to this issue of great concern in Italy and the rest of the continent.

A good start could be the German health minister Jens Spahn's call for 100,000 European border guards funded by the European Union. A fairer burden sharing of the costs of processing arriving refugees would also help, including comprehensive reform of the EU Dublin regulations, though with no compulsory member state refugee quotas.

Such an initiative would be real reform in Europe. It would make it more difficult for populists in Italy to make the case against the European Union and the common currency and would result in good policy and politics for all of Europe.

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