Italy: When Trumpism Hits Euroland

May 29, 2018, when Italy’s new populist government formed by the far-right Lega Nord and the far-left Cinque Stelle came into being, will be an important date in the history of the euro.

It is the day when the unthinkable happened: The myth of the unbreakable nature of the common currency collapsed.

For the first time, markets speculated openly that Italy could exit the monetary union. This had previously been considered only a very remote possibility.

Accordingly, the yields on Italian government bonds shot up within a few hours, with 10-year maturities above 3%.

Trumpism has come to Europe

This was not just an “industrial accident.” It is rather the beginning of a new era. Perhaps the best way to put it is that Trumpism has come to Europe.

The U.S. president stands for a populist economic policy. He questions everything. He does not abide by the rules. He also feels no longer bound by long-standing alliances. He cherishes the fact that he is unpredictable in his actions.

Now we see this playing out in Europe for the first time to a greater extent. All of a sudden, the pro-European orientation of Italian politics, above all the affiliation to the euro, is under serious doubt.

The same applies to the Maastricht treaties which prioritize price stability and sound public finances. Italy’s apparent turn is all the more stunning – indeed self-defeating – as the country has made extraordinary efforts in recent years. It managed to reduce the public budget deficit to below 3% and to achieve a current account surplus.

Now, one could say that the Lega/Cinque Stelle plans are all unreal and should not be taken so seriously. After all, according to surveys, the Italian population is still in favor of the euro.

But because the now ruling parties, as in the case of the American president, are democratically legitimized, this changes the equation considerably.

True, they may change their opinion over time. There may also be new elections. But as long as that is not the case, we have to accept it the way it is.

Populist monetary union

From now on, we will no longer live in the orderly world of the Maastricht treaties, but in the world of a “populist monetary union,” if you will.

The euro and European banks are becoming more vulnerable to crises of confidence and international capital movements. The advantage of the euro over the former fixed-income system of Bretton Woods is gone.

Is that not too pessimistic a view? After all, the United States of America has done quite well with Trump so far. Yes, there is more uncertainty, but the financial markets were still working properly. Employment is up.

The story for Europe is quite different. Not only are Europe’s common currency and its institutional fabric still rather youngish.

Interest rates and populism

The new populism in the EU will have rather direct effects on interest rates in the euro area. One could even speak of a direct “populism penalty.”

As the graph shows, before monetary union, Italy’s interest rates were very high. They were one of the reasons why Italy joined the euro.

German and Italian interest rates

Then, after the introduction of the common currency, there was almost complete synchronization of interest rates. The spread was minimal. Indeed, it was far too low and did not sufficiently reflect the risk differences. In this respect, everyone was happy that the spreads rose again after the financial crisis 2008/2009.

Now comes a new phase. The spread now shows not only the different economic conditions, but also the degree of populism in the individual countries.

The greater the likelihood that a country will not stick to the rules or question the euro, the higher the spread. Beyond Italy, this also applies to other countries, if and when populism takes hold there.