December 8, 2017

News in Charts: Italy and the itcoin

by Fathom Consulting

On the surface it appears that Italy is finally beginning to enjoy a cyclical upswing similar to the rest of the euro area, with growth having accelerated in 2017. Fathom, however, predicts that this upturn will be short-lived. In the long term, structural problems (including excessive levels of debt, the prevalence of non-performing loans, a declining population and anaemic productivity growth) will continue to hamper the Italian economy. In the near term, uncertainty surrounding the upcoming election, and the possible introduction of a parallel currency, may weigh on confidence heading into 2018.

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The latest opinion polls suggest that the election is unlikely to produce a decisive outcome, with none of Italy’s three major political blocs likely to win a majority. It therefore seems inevitable that Italy’s next government will be a coalition. While a grand coalition formed between the centre-left and centre-right blocs would probably lead to a near-continuation of current policy, an alliance between the centre-right bloc and the populist Five Star Movement could generate a period of heightened economic and financial market uncertainty, especially given that both blocs have previously indicated support for a parallel currency scheme.

Regardless, of the electoral outcome, the outlook for Italian public finances remains grim. Years of structural reforms and anaemic economic growth have led to little appetite for further austerity. Indeed, with all major political parties currently proposing some form of fiscal expansion, Italian sovereign debt is unlikely to decline significantly from its current level.

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As Fathom highlighted in a recent note to clients (‘Europe’s dizzying debt dynamics’), Italy’s public finances remain precarious, with the country’s debt at risk of spiralling out of control. According to Fathom’s proprietary debt calculator, Italian debt stability remains conditional on a commitment to fiscal restraint and continued access to cheap funding. The current spending plans of Italian politicians do not appear to reflect this reality. At present, Fathom calculates the market-implied probability of Italian default over the next five years to be less than ten per cent. Financial markets, therefore, have either not priced in Italy’s post-election fiscal plans or simply do not trust the politicians to implement what they have proposed.

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Another headline-grabbing proposal is for the Italian government to introduce a parallel currency that would circulate alongside the euro. Similar proposals currently have the support of the three of the four largest political parties and cannot, therefore, be completely ruled out.

According to the proposals, the government would pay its own suppliers, public sector employees and state pensions using a combination of euros and the new currency (hereafter dubbed the ‘itcoin’). Those receiving itcoins could in turn use them to make direct payments to the government (e.g. for tax purposes). Crucially, the government would commit to accepting these payments. As a result, it is possible that itcoins could also be used to make payments to the private sector. Proponents argue that firms would accept the parallel currency as means of payment since they could in turn use it to pay their own tax liabilities.

Advocates claim that the itcoin would boost the economy since it would enable the government to pursue a fiscal expansion that would boost growth through multiplier and liquidity effects. The feasibility of the itcoin, however, is subject to debate. Under current proposals the itcoin would not formally be given the status of legal tender (i.e. private sector vendors would not be forced to accept it as means of payment). Arguably, therefore, possessing itcoins would be viewed as a less attractive prospect than holding euros. Consequently, there would be little reason for shopkeepers to accept itcoins as a means of payments and the parallel currency might plausibly be expected to fall out of circulation. Indeed, this is the predication of Thiers’ Law.

Aside from debates over the itcoin’s feasibility, there are also questions over its legality. European laws currently state that the euro must be the only currency given the status of legal tender within the single currency bloc. Despite protestations by itcoin advocates, the EU would probably view the itcoin as incompatible with this law and consider debate over a parallel currency as indistinguishable from a debate over euro membership. From their point of view, the introduction of the itcoin could be the start of a slippery slope which might lead towards a euro exit.

However, Italexit is not Fathom’s central forecast, even if a eurosceptic coalition is formed. Given that support for the euro remains solid, proposals for the itcoin’s introduction may instead be used as a bargaining tool in negotiations with the EU over future budgetary plans. Arguably, financial markets take a similar view — according to Fathom’s calculations the market-implied probability of Italexit is currently 3.4%.

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Ultimately, for the itcoin to be introduced, the Five Star Movement would have to show willingness to enter coalition negotiations with the centre-right, and public support for the euro would have to decline significantly. While neither of these events appear likely for now, they cannot be ruled out altogether.

In any case, the election is unlikely to result in the formation of a strong and stable coalition government. As highlighted above, the Italian economy faces deep-rooted problems, many of which can only be resolved through further structural reforms. However, years of reform fatigue have left little appetite for more and the Italian economy is forecast to continue to bump along the bottom, with the country’s structural problems unlikely to be resolved any time soon.


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