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Italy on the Brink

LONDON – Political instability in Italy is nothing new. But Italian voters’ rejection of constitutional reforms in a referendum has not only led Prime Minister Matteo Renzi to resign; it has dealt another blow to a crisis-ridden European Union. In the near term, Italy’s ongoing banking crisis could flare up again and threaten European stability; in the longer term, Italy may have to leave the eurozone, which would put the single currency itself at risk.

The “No” side was widely expected to win. But the scale of its victory – a whopping 59% of the vote – was shocking, and largely a triumph for anti-establishment forces, particularly the Five Star Movement. The movement, led by the comedian Beppe Grillo, is leading in opinion polls, supports holding a referendum on eurozone membership, and is now demanding an immediate general election.

Most Italian commentators have downplayed the referendum’s significance for the rest of Europe. They argue that a new caretaker government, probably led by the technocratic finance minister, Pier Carlo Padoan, will reform electoral laws to keep the Five Star Movement from power. And even if the Five Star Movement captures a majority in the Italian Parliament’s lower house, it will not have a majority in the Senate, so it cannot form a government, unless it breaks its pledge not to join a coalition. In any case, the argument goes, a eurozone referendum would be hard to deliver, because it would require a constitutional amendment.

All of that may be true, but it misses the big picture. Renzi was the pro-EU establishment’s best – and perhaps last – hope for delivering the growth-enhancing reforms needed to secure Italy’s long-term future in the eurozone. Muddling through with a weak technocratic-led government amounts to waiting for an accident to happen. And, with the far-right Northern League and former Prime Minister Silvio Berlusconi’s Forza Italia also aligned against the euro, an anti-euro government is likely to come to power at some point – perhaps after the next general election, which is due by 2018 (but could be held as early as next spring). Then all bets will be off.

The immediate problem is Italy’s zombie banks, which are inadequately capitalized, insufficiently profitable, and saddled with bad loans. These banks need to raise fresh capital, which was already proving difficult before the referendum, and now may be impossible amid the heightened political uncertainty.

Capital is fleeing Italy, as Carmen Reinhart observes. Government-bond yields, which rose sharply in the run-up to the referendum, have so far remained steady; if they were to spike, however, Italian banks’ fragile balance sheets would deteriorate further. And, because the European Central Bank has already bought many Italian bonds through its quantitative easing (QE) program, it could not readily intervene further.

The most endangered bank is Monte dei Paschi di Siena (MPS), which is trying to raise €5 billion ($5.3 billion) in new capital. If it fails to do so, the government will likely furnish it with public money to stave off a collapse. That, in turn, would require MPS’s junior bondholders to take losses, unless the government breaches the EU’s bank “bail-in” rules, which would undermine the eurozone’s new banking union. While small investors who were mis-sold bonds could be compensated, large, politically powerful ones would not be.

MPS’s travails could have wider economic repercussions. Italy’s largest bank, UniCredit, which is better positioned than MPS, could struggle to raise the more than €10 billion that it is seeking. Because many eurozone banks remain weak, the crisis could then spread.

In the longer term, Italy’s eurozone membership could be at risk. Unless Italy enacts radical reforms to address its sclerotic growth, it is hard to see how it could ever have a viable future in a dysfunctional monetary union dominated by a mercantilist, deflationary Germany.

Italy’s economy is no larger today than it was in 2000. Its share of global exports has plummeted. And despite the boost from the ECB’s QE program, a weak euro, and the looser fiscal policies of recent years, output is growing at an annual rate of less than 1%. Moreover, Italy could barely stabilize its public debt – which now amounts to 133% of GDP – even when bond yields were reaching record lows. An economic downturn or rising interest rates would thus send public debt soaring again – and Italy cannot count on the ECB to continue buying its bonds indefinitely.

Italy’s political situation – marked by a sense of never-ending misery and growing resentment against the EU and Germany – is equally unsustainable. Youth unemployment is at 37%. Eurozone fiscal rules continue to chafe. And EU governments have done little to help Italy cope with the refugee crisis.

Italians used to be enthusiastically pro-European, and saw EU governance as preferable to corrupt domestic mismanagement. But support for the euro, the EU, and the country’s pro-EU establishment has plunged.

The mere possibility of Italy leaving the eurozone – which would entail the redenomination of €2.2 trillion of Italian government bonds in devalued lira – could spark financial panic. What’s more, Italy is too big to bail out, and an anti-euro government may be unwilling or unable to agree to the strictures of an EU loan, which would be necessary for the ECB to quell the panic. It is also implausible that Germany would offer to enter into a eurozone fiscal union that entails pooling its debts with Italy’s.

In addition to stronger demand in the eurozone, Italy desperately needs bold leadership – to restructure its banks, write down unpayable corporate and household debts, reform its economy, boost investment, and clean up its politics. So it is scarcely reassuring that both the eurozone and Italy are likely to try to muddle on for now.