For its part, the EU should do more to help Italy take the tough steps it needs. The European Commission, the European Central Bank, and the German government have erred in insisting on rigid enforcement of the EU Stability and Growth Pact, particularly the 3%-of-GDP cap on fiscal deficits.
Although some countries have been allowed to breach the deficit cap during challenging times, Italy is almost never afforded much accommodation, owing to its high debt levels. Yet as the experience of Belgium and Japan shows, high government debt can be reduced only through sustained economic growth.
Complicating matters further, some reforms to boost long-term productivity can actually reduce growth in the short term. Thus, any government enacting such measures will need to have the option of pursuing counter-cyclical stimulus.
Another problem concerns monetary policy. The ECB could stand to be more broad-minded in how it pursues its inflation target of just under 2%. That target, along with Germany’s own 2% target, leaves Italy locked into a state of low inflation, even when it could benefit from more monetary-policy stimulus.
Under these conditions, the EU authorities would do well not to oppose the current Italian government’s plans too aggressively. If mainstream liberals are worried about the implications of a democratically elected populist government, then they should worry even more about what could come next if economic circumstances worsen. At this stage, Italy needs stronger nominal GDP growth – plain and simple.
There has been a lot of commentary about the rise of populism what that means for the state of the social democratic centrism which has been the dominant force in European politics for decades. However much less discussion of the demands put on Eurozone consumers, particularly on the periphery as a result of the sovereign wealth crisis.
The bald facts are that banks and pension funds from the core Eurozone countries made bets on the growth of peripheral economies which did not work. The policy response was to national huge swathes of the German, French and Dutch banking sector while simultaneously forcing peripheral sovereigns to absorb private sector debts rather than write them down.
The austerity that imposed to ensure those debts be paid off has tested the patience of electorates who have already lived with close to a decade of diminished standards of living. Against that background is perhaps surprising that it took this long for populist movements to emerge. I agree with Jim O’Neill that the EU has little choice but to bleat about Italy’s spending plans because to sanction the country would only lend fuel to the populist movement. The only way to blunt a populist revolt is with more money. That suggests Italian yields are likely to rally in response to wider deficits.
The biggest question is how long it will take for the rest of Europe to wake up to the popularity fiscal stimulus would be greeted with by other populations and what that could do for the sustainability of the political elites in those countries.
The Euro STOXX Index broke downwards from an 18-month range, which has type-3 top formation characteristics two weeks ago and a clear and sustained move back above the trend mean will be required to question medium-term scope for continued downside.