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31 October 2018

‘This Is an Existential Test of the Eurozone’

BY MICHAEL HIRSH

In an unprecedented move, the European Union this week rejected Italy’s 2019 draft budget, saying it posed a threat to Europe’s economic stability. The decision is part of a confrontation between the European Commission and the right-left coalition government in Rome consisting of the Northern League and Five Star Movement parties. Adam Tooze, an economic historian at Columbia University, believes the move could trigger a global economic crisis. Tooze is the author of the recent book Crashed: How a Decade of Financial Crises Changed the World. What follows is his conversation with Foreign Policy.

Foreign Policy: Does the Italian budgetary crisis and the European Commission’s response surprise you in any way?


Adam Tooze: No, it doesn’t. It’s been in the works ever since the new Italian government took shape and emerged earlier this year. If you listen to senior figures in the commission, it was a pretty clear they were going to draw a line. There’s been jousting between Brussels and Rome, of a quite unpleasant and really rather unusual kind. There’s a real sense that [Matteo] Salvini of the Northern League represents a clear and present danger to values of the EU in general, setting aside the rights and wrongs of EU policy on the refugee question and whether or not they have provided help to Italy appropriately.

So I think there’s no patience in Brussels for the Italian government and a real sense that the best way to defuse what is clearly a very dangerous situation is to raise the stakes at the beginning. This is an unprecedented action after all.

FP: How does this play out most immediately in terms of the rejection of the budget? They now have three weeks to resubmit it, correct?

AT: It’s very difficult to call this from the outside. Italian politics is an extremely complex mechanism. … I genuinely don’t think we know an answer. The real risk is the political decision-makers underestimate the dynamic in the financial markets, and the markets are not the all-powerful cosmic force that they’re often made out to be. Especially with the ECB [European Central Bank] still a major buyer of Italian bonds. But if you stir them up to the extent the Italians and Europeans seem willing to do, then you can end up with an unstoppable momentum. We’ve already had one downgrade of Italian sovereign debt. If we were go into a sequence of rapid-fire downgrades, it might be pushed below the threshold of investment grade, and that then triggers a bunch of automatic responses. This isn’t a matter of a bunch of shadowy vulture speculators. This is simply a matter of institutional investors who have a mandate to hold assets of certain quality. If Italy loses that ranking, then it triggers an automatic disinvestment from Italian bonds, which will be very risky and have ripple effects on the entire Italian banking sector, which holds almost 400 billion euros worth of Italian sovereign debt. … That’s really the nightmare scenario.

FP: Could the Italian euro crisis radiate out far enough to trigger a global financial crisis, at a time when central banks might be ill prepared to confront it because interest rates are already so low?

AT: Insofar as Europe can trigger one, this is the mechanism through which it might. Italy is a very big piece of the global financial markets. It’s the fourth-largest issuer of sovereign debt in the world. Right now, we’re in a delicate situation in the financial markets generally. The balance in particular between inflated stock valuations in the U.S., despite recent corrections, and the tightening interest rate situation, which destabilizes the bond market, is a very precarious one. You could easily have offsetting effects, where panic-stricken money flees Italian debt into safer German and American debt. American debt is still, believe it or not, a safe haven asset. But for the eurozone itself, this is a mortal risk. This is an existential threat.

FP: Much more so than Greece was.

AT: Oh, an order of magnitude larger. It’s a $3 trillion debt problem, not a $300 billion debt problem. None of Europe’s rescue mechanisms as they’re currently configured are large enough to deal with a full-blown Italian crisis. The thing that would fix the entire problem is a “whatever it takes” type statement from [ECB Chairman Mario] Draghi. And so long as the ECB continues to buy Italian debt as it is currently doing, though it is committed to tapering those purchases at a bad moment, for broader considerations of the state of the EU economy and the need to give itself some room for maneuver in case there should be a downturn. But the ECB is the answer. In the long run, you can talk as long as you like about fiscal adjustment, the construction of new institutions for the eurozone, but if we enter the terrain of an actual bond market panic then the only actor with the firepower to stabilize the situation in a matter of hours and days is the central bank.

And of course this raises explosive political issues for the eurozone. The AfD [Alternative for Germany party], the big challenger on the right in Germany, was created not as a response to the refugee crisis of 2015 but a response to what German conservatives consider the compliant, complacent collapse of the Merkel government over the eurozone. They want a hard line. The last thing [Chancellor Angela Merkel’s ruling Christian Democratic Union party] needs right now is for the ECB to have to engage in emergency action so as to rescue Italy.

FP: What about the role of the U.S. Federal Reserve? As you pointed out in your book, it was only the Fed’s secretive lending role that helped rescue Europe after 2008. Would this be necessary again?

AT: What’s really striking is that those risks have been considerably unwound. The reason why the Americans had to act in 2008 as they did is that the money market mutual funds were still entangled in Europe, and the American economy was much more fragile than it is now. So there is much less prima-facie reason for immediate American action. I think absolutely the Fed would honor swap-line commitments it has to the ECB if there should be any issue. But I think what’s very interesting is that the Trump administration has signaled very clearly in its position on the IMF that [while] it will be proactive in bailing out emerging markets, it has signaled absolutely explicitly that it sees no role for the IMF in European crises. And throughout 2010 and 2012, and all the way through the Greek case, the IMF is implicated in eurozone crisis fighting. The largest single commitment the IMF has ever made was to backstopping Europe in May 2010.

I don’t think there’s any prospect that the Trump administration would support anything like that. And I have to say it’s a tough but completely healthy line to be taking. It’s reasonable in that the Europeans haven’t bitten the bullet here and sorted out what needs to be sorted out.

FP: But the Federal Reserve acts more or less independently.

AT: But the Fed’s role is limited to liquidity provision. If there was a dollar shortage, I think the Fed would honor their swap line commitments. [Federal Reserve Chairman Jerome] Powell is a very conventional central banker. And I don’t think the Trump administration would kick up much of a fuss, though of course relations between the administration and the Fed are worsening by the hour. One would have to see. You could well imagine a Trump tweet that asks, why are American interest rates going up when the Fed is providing liquidity to Europe? That’s not a tweet anyone wants to see. It wouldn’t make much sense, but one can’t put it past him.

FP: Let’s go back to the themes of your book and the rise of populism. In Italy you have this strange chimera of a coalition, with left-wing populists uniting with a right-wing party. Isn’t this populist-driven crisis exactly what you were warning about?

AT: In communicating with American audiences, I always find it helpful to compare Italy to California and Spain to Texas. Imagine if we were to face a situation where California had a 35 percent unemployment problem. And I’m not talking about minority kids in ghettos; I’m talking about, what if a third of everyone coming out the University of California education system was unemployed. In Spain, at the height of the crisis, half were unemployed; imagine if half the kids in Texas were unemployed. It would produce some serious political backlash, and it would be hard to predict which way it might go. It might a Bernie Sanders thing, it might be some hideous white nationalist thing… That’s the level of crisis we’re talking about.

FP: Are we witnessing the beginning of the unwinding of the eurozone concept because of intractable structural problems? The failure to produce budget discipline, the dominance of Germany and its austerity thinking?

AT: You’ve got to distinguish three elements of the story. Italy has been in an austerity regime for 20 years, more than in Germany. America would pop out of the eurozone austerity regime so quickly you couldn’t finish that sentence. So Italy has been running a very tight ship. The problems are the legacy debts of the ’70s, ’80s, and early ’90s, which are huge. … That means they have a modest budget deficit. Which this government is modestly trying to increase, but that puts it in violation of these European rules. So it’s important to say that whatever is going to cause the eurozone to fail is not a lack of fiscal discipline. The problem is growth. The Italian economy is not growing. It’s not obvious how you get growth in Italy.

But to get back to your question, I do think this is an existential test of the eurozone as it’s currently configured. This is indeed crunch time. This is a major, major test at this point. Whether or not we’re witnessing the beginning of the unraveling, it’s too early to say. We haven’t really judged the German reaction mechanism yet. Nor are we talking about concrete exit scenarios. Though least likely of all, because it’s so catastrophic, is an Italian exit. …. I think we’re a long way form that kind of scenario. Five Star is not an anti-European party. But we are going into a phase in which the eurozone is going to face basic questions about its organization and priorities.

FP: Setting aside Italy and the eurozone, broadly speaking, how much of a danger of a new global financial crisis are we facing right now?

AT: I think we have to distinguish between the risks of a recession and the risks of a crisis. I don’t think a recession is a risk so much as an inevitability at some point, in the next 18 months to two years. The American economy cannot continue in its current phase much beyond that. In terms of crisis risks, Italy ranks high as a globally significant event. The other place where you could have a globally significant trigger is emerging markets. Everyone needs to be watching the China situation every day. That’s the central driver of global growth right now—the emerging markets. And they’re no longer emerging; they’re 65 percent plus of global growth. … So China, China, China is really the mantra right now.

This interview was edited for length and clarity.

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