Italy votes for instability

In at least three respects, the decision by Italian voters to reject Prime Minister Matteo Renzi's constitutional reform proposals in a referendum differs from Brexit and Donald Trump's election. First, the opinion polls got it right, and it wasn’t a big market shock either. Second, it was not a populist revolt per se, as all opposition parties supported the No campaign, as did many within Renzi's Democratic Party, academics, legal professionals and notable moderates such as former Prime Minister Mario Monti. Third, unlike the UK and the United States where political outcomes have increased the likelihood of economic decline over the medium term, Italy is already in an economic and financial crisis, which may now of course worsen.

All of that said, the "No" vote raises the temperature of instability in Italy and marks a victory for both the Northern League and the Five Star Movement, which are blatantly populist parties. According to the polls, the latter would win a second round of parliamentary elections under current law. It may have to wait, for although Renzi has resigned, President Sergio Mattarella will now try and patch together a caretaker government in the next few days. If Mattarella were to fail, then there could be elections in 2017 (along with those in France, the Netherlands and Germany) ahead of their scheduled date in May 2018. Otherwise, a new government would probably take up some of the proposals for electoral and constitutional change.

But sooner or later the Five Star Movement, co-founded by comedian Pepe Grillo in 2009, will get its chance in national elections. It might have fared better had the referendum passed, because those proposals would have handed much power to the executive branch of government, lessening the need to form a governing coalition. We don't know that Five Star would win an election outright, or with whom it might govern if it did. But it favours a referendum on whether Italy should stay in the European Union. According to polls, a majority of Italians want to remain in the EU yet, as we have seen in the UK and the US, this cannot be taken for granted. These tensions will hang over Italy for the time being and until national elections are over. In the meantime, Italy has voted, in effect, for more instability.

In any event, there is urgent work to be done and Renzi's referendum has been an unnecessary distraction. Away from the public's gaze, another, perhaps more important, vote has been going on—one of confidence in the Italian economic and financial system. It is all too clear that this vote is a huge thumbs-down. Simply put, Italy has been suffering capital flight for much of the last two years, and it's been getting worse in the last few months. Unless this can be arrested soon, the country’s economy will continue to suffer and a banking crisis could erupt, threatening systems and structures throughout the euro system.

This week, one of Italy's beleaguered banks, Monte dei Paschi di Siena, the third largest in the country, is supposed to be raising €5bn in new capital. Seven other banks are also as close to insolvency as makes any difference and also need to raise capital. Even Unicredit, the largest lender, needs to raise about €13bn. Earlier this year, the government estimated that troubled financial institutions would need to raise about €40bn.

The backdrop here, of course, is the deadweight of bad or non-performing loans, which has arisen not so much because of reckless lending, but because of years and years of no growth in the economy, and the evolution of zombie loans to zombie companies. When other Eurozone countries had to address comparable problems in recent years, they used the balance sheet of their governments to support their banks. Spain, for example, created a bad bank to buy up bad debts, and Ireland funded a bailout by taking the debts on to its own books.

But now banking union regulations now forbid the use of “state aid,” meaning that Italy would have to pass the costs on to depositors, many of whom are retail depositors who own bank bonds. Many more own government bonds, whose values have been under pressure as the financial viability of the banks has declined. If the new or next Italian government cannot get the rules changed or exemptions granted, and depositors effectively have to pay for broken banks, the political backlash against Rome could be even greater than we have seen so far.

Partly reflecting the slow-burning banking crisis, capital has been leaving the country in droves. Because Italy doesn't have its own currency or control over its interest rates, capital flight doesn't look like it would in the UK, the US or China, for example. If the monies leaving Italy for other countries due to trade, transfers and normal capital transactions exceed the monies coming in, the Bank of Italy (the central bank) has to borrow money from the European System of Central Banks, which lives under the umbrella of the European Central Bank.These borrowings are recorded by the ECB every month and normally tend to fluctuate around small margins. They are known, technically as Target 2 balances.

During the euro crisis from 2011-13, Spain, and Ireland acquired largest Target 2 deficits, which were subsequently repaid in Ireland's case, or reduced in Spain's. Italy's Target 2 deficit rose sharply in 2012, but fell away significantly in 2013-14, only to erupt again over the last two years. It now stands at 20 per cent of GDP, which Italy's highest ever deficit vis-a-vis the euro system. It doesn't necessarily portend an imminent crisis in the eurozone, but its existence and trend point to severe financial stress.

At its heart, Italy's crisis is really about economic stagnation and has been so pretty much since the birth of the euro in 1999. In constant prices, income per head is now about the same as it was in 1995, and over 10 per cent lower than it was in 2006. The growth funk is partly related to the constraints imposed by euro membership but also to an array of made-in-Italy phenomena, including long-running structural problems in the south of the country, political paralysis, over-regulation, and corruption that have stifled investment, job creation and productivity. Since he came to power at the start of 2014, Renzi's government, focused mainly on constitutional issues, presided over growth of less than 2 per cent, compared with a eurozone average of over 4 per cent.

None of this looks likely to change much in the next year or two. If Italy's banking crisis blows up, the political backlash will intensify and the eurozone likely succumb to crisis. If the authorities are able to deal with this, or at least stabilise it, then the country could soldier on until new national elections. At that point, we would know better whether Italy and the eurozone were still compatible, and indeed whether the eurozone was still salvageable. Provided of course, Marine Le Pen didn't beat Italy to it.