Among developed nations Italy, along with the US and the UK, stands out on account of the combination of very pronounced income inequality and high barriers to social mobility. These are reflected in the ‘Great Gatsby Curve’ (see Exhibit 1 below), which illustrates that income inequality and the ability of those in the next generation to move up the economic ladder compared to their parents, are correlated.
As it turns out, these same three countries have also undergone a political revolution of sorts over the last couple of years.
The UK voted – unexpectedly – in favour of Brexit in June 2016. The US elected – unexpectedly – Donald Trump as president in November 2016. And after a general election in March 2018, a populist, Eurosceptic coalition government was elected in Italy, a founding member state of the European Union (EU).
In fixed income, it is all about debt and to what extent the aforementioned political developments could impact the debt trajectories and debt sustainability of those countries. In what follows, we focus on Italy, which currently has a debt-to-GDP ratio of about 130%. Since it is locked into the euro, there is no independent monetary authority to enable the country inflate its way out of this pernicious situation.
As investors, we have been thinking about the Italian debt end-game ever since the eurozone sovereign crisis of 2011/12. So far, we have mainly seen two scenarios unfold:
- The standard approach when faced with a high level of indebtedness is to implement product and labour market reforms which raise productivity and trend growth, combined with fiscal prudence. This was attempted to some extent during the Monti and Renzi governments but ultimately with limited impact. The implementation cost is exclusively carried by the local population in the form of a higher pensionable age, less job security, more competition, etc. At the current juncture, this path is unlikely to be revisited, except perhaps under external pressure.
- The current government’s approach is one of broad-based fiscal stimulus, which is supposed to lead to stronger GDP growth through a high fiscal multiplier. While this looks painless on the surface, financial markets seem to have already passed their verdict by widening the BTP/Bund spread, signalling to the Italian government that this course of action will not lead to a long-term solution.
To assess what may happen next, we have to ask ourselves how a populist government differs from a traditional government.
It can be argued that a populist government may be more inclined to have non-domestic agents share in the costs of any final debt resolution as well as in addressing the inequality issue affecting most of its voters. In this context, four additional scenarios could develop in the near future:
- One-off tax event: imposition of a property or wealth tax to refill the government’s coffers. The burden of such a measure would be almost exclusively borne domestically but would clearly impact the richer part of the population.
- Debt restructuring: to make the debt burden more manageable, most likely via a Private Sector Initiative (PSI) similar to that in Greece in 2011. We know that about 75% of the debt is in private hands, with most of it sitting with domestic institutional investors and actually very little with domestic retail investors. Because foreign investors hold about one-third of the debt in private hands, the cost of this measure would be shared between locals and foreigners.
- Italy exits the eurozone: by playing the devaluation card. Italy may also have to exit the EU under this scenario. It would inevitably trigger a very strong, one-off inflation shock for Italians, hurting local creditors but helping local debtors, and facilitating some inequality rebalancing. But it would also adversely affect eurozone member states since the eurozone/EU could unravel. In addition, there is the thorny issue of the Target 2 balances in the euro system, which could inflict a steep cost on the remaining members of the system as Italy’s net liabilities amount to EUR 500 billion.
- Eurozone fiscal union: rather than leading to an exit from the eurozone, rising fiscal stress in Italy could prove to be a game-changer as a catalyst for further integration and a much broader political solution. This would be by far the most positive outcome. While it might look like eurozone members picking up the tab for Italy, there are some caveats. Prior to joining a fiscal union, Italy may be asked to go through a restructuring of its debt, as discussed in the previous scenario.Additionally, Italians may still need to implement some much-needed structural reforms as part of such a solution, which would likely come in the form of a new treaty to be ratified. Given that aggregate eurozone debt amounts to 90% of aggregate eurozone GDP, this would also be a sustainable outcome.As a silver lining, there would presumably be a convergence in political economy over the longer term between the member states of a fiscal and monetary union. In other words, Italy could potentially roll down the ‘Great Gatsby Curve’ towards the rest of Europe, i.e. with less income inequality and lower barriers to social mobility.
In conclusion, other than maybe the one-off tax event, the scenarios laid out above imply a further widening of BTP/Bund spreads from their current high levels. So disruption at the ballot box and the formation of a populist government in Italy suggests a much more stressed environment in the future for Italian government debt.
Exhibit 1: The Great Gatsby Curve: More inequality is associated with less mobility across the generations
Source: Miles Corak, Journal of Economic Perspectives – Volume 27, Number 3 – Summer 2013 – p.83