It has been a quiet week in the Brexit talks as both sides prepare internal positions ahead of the June Council summit, but it has been a far from quiet time in Europe, with the situation in Italy threatening to open up deep divisions within the EU and posing potential existential questions about the future of the Eurozone.
It is worth spending some time looking at the wider European situation, because Brexit is not happening in isolation. It is unfolding against a background of deep dissatisfaction across Europe with the current political set-up.
Many in Brussels dismiss Brexit as a distraction caused by a local tantrum which has no great significance to the future of the European project going forward. Yet in many ways Brexit was the first clear symptom of a disease that has the potential to fatally undermine the European Union. At the heart of the Brexit vote was dissatisfaction with EU policy making, specifically the feeling that national governments had lost the ability to either influence Brussels or to effectively rule themselves.
Whether this complaint is true or not is the subject of detailed debate right now, but the reality is that many people feel that this is correct. The UK experience in trying to navigate its way out of the many EU structures and policies has strengthened this argument as only now is it becoming apparent just how much influence the EU has over so many areas of economic life in the UK.
Yet the UK is not in the Euro, the single most sovereignty sapping EU policy. As a result the UK is far less influenced by EU policy than any country that uses the Euro. Brexit highlighted the initial symptoms, which were already evident in the European election in 2014, where anti-European parties had significant success. However it is Italy that has the potential to turn those symptoms into a full blown epidemic which could, and I stress could, blow apart the Euro and potentially the European Union.
The Euro was always primarily a political project. It was a stepping stone to a far more complete political union. But from an economic point of view the Euro was never sustainable without the political union which it was intended to bring about. Similar monetary unions have never lasted long.
The Euro is therefore currently in no man’s land. To survive it needs political union, but the public support doesn’t exist in member states to cede the sovereignty necessary to create that political union.
The anger in Italy is a clear example of that lack of public support. The Italian economy has stagnated since the introduction of the Euro, its previously strong manufacturing sector has been hit hard. Youth unemployment is high. Like other southern economies like Spain, Portugal and Greece, the rigid budgetary discipline of the Eurozone, together with the strong value of the currency, have proved ill-suited to the demands of these economies. Yet on the whole the public (at least initially) supported the Euro because it brought currency stability and made individuals feel richer, as on the surface salaries were at similar levels to those in Germany or the Benelux countries, allowing a consumer boom and providing a huge increase in European export markets for German companies, who became the chief beneficiaries of the Euro.
But as the UK experienced with the ERM in the early 90s you can only patch over these differences for so long. The German economy demanded low interest rates but the periphery economies needed the opposite. Spain, Ireland and Portugal quickly had housing booms that just as quickly went bust, taking the banks with them and loading up their governments with huge debts and current account deficits.
As the whole Eurozone was affected, Greece, by far the least competitive Eurozone economy, went to the brink. Italy was not far behind.
This meant that Germany, as the largest and strongest economy, became the key lender to these governments. They demanded public spending reductions and policy changes in exchange for their financial support as they had done in Ireland and Portugal. In Greece, however, the political will was not there to implement these reforms and the economy was probably not strong enough anyway. This led to the election of a far left government and a referendum rebelling against these changes and the fact that they were imposed from abroad. Yet despite all the rhetoric and the referendum result Greece backed down, took the bailout and implemented the bailout terms. Seething resentment remains in Greece.
That leads us to Italy and the current situation. In 2011 a technocratic government led by ex-EU commissioner Mario Monti was effectively imposed on the country in the wake of the debt crisis. Only the far right Lega Nord opposed his nomination. Out of this event the Five Star movement emerged. Anti-establishment, populist but all over the place ideologically, they quickly grew, dominating the European elections in 2014 and a few months ago winning a general election with enough votes to create a coalition government with the Lega Nord.
What happens next will be the subject of conspiracy theories for years. Many in the Lega Nord want a referendum on Euro membership, the Five Star movement are less keen but still want to vastly change the way the Italian budget works, and to spend a lot more. Brussels and Berlin took fright and it appears Italian political expediency also played a part. The Italian President Sergio Matarella vetoed the coalition pick for the Finance Minister, mainly because he feared the markets would take fright due to his reported wish to take Italy out of the Euro. He has proposed a technocratic Prime Minister instead to steady the ship. Fresh elections are now likely and although the biggest beneficiaries are likely to be the Five Star movement and Lega Nord, there is still half a chance that this episode has opened the door for the return of ex-PM Silvio Berlusconi and his centre right alliance. They could yet win that election.
So Italians voted for change yet the establishment, potentially in cohorts with Brussels and Berlin, have blocked that change.
This is a recipe for disaster, compounded by Germany’s EU commissioner telling people that the markets will show people in Italy how to vote.
The fact that the European Commission slapped him down so quickly shows just how dangerous the situation is getting. People are angry with economic stagnation, which many blame on the Euro. They are angry with the fact that their vote doesn’t change anything and they are angry that Germany appears to dictate the Italian budget. For a German to suggest the markets are the ultimate arbiter is also a grand folly, given the propensity for European voters to fall for simple anti-capitalist far left rhetoric.
The Euro has put Germany in an impossible situation. (It is little known that many Germans opposed the introduction of the Euro and felt it was forced on them by Mitterrand and Thatcher as the price of reunification). Germany is asked to bail out other Eurozone economies when they get into trouble and they have to, otherwise the Euro will collapse, hurting everyone. They are justified in asking for budgetary restraint in return for their money. But politically this is damaging everyone. People in Germany are angry that they keep having to bail out profligate southerners, whilst the Italians, Greeks and others see Germany as effectively ruling them as colonies.
This tension will explode at some point. The most viable option (Eurobonds) would institutionally cement transfers from Germany to the south as permanent structures whilst permanently imposing German budget discipline on those economies. More of the same in other words and unlikely to be politically sustainable anywhere.
The other option, often quoted in the British press, is that Greece or Italy or other countries should just leave the Euro, as if it were an easy thing to do.
Yet as Greece showed and as I believe Italy will probably also demonstrate in the end, once you are in the Euro it is virtually impossible to leave. Apart from the fact that although unpopular, fiscal discipline was one reason why many of these countries joined the Euro in the first place (many felt they couldn’t trust their own governments to look after the economy so Brussels was a better bet).
Leaving the Euro would create an immense short term destruction of private wealth. Italians would go from a strong global currency to one threatened by hyperinflation immediately. Private wealth would flee, meaning capital controls would need to be introduced, further dampening foreign investment.
A strong economy would recover over time, but it’s not clear that Italy’s economy is strong enough. As a result many Italians, when push comes to shove, would probably not want to leave the Euro and even if they did, it’s not clear that they could do it in an orderly manner. The Brexit negotiations have shown that there is little political will in Brussels for orderly withdrawals from EU policies.
So it is easy to see why so many fear Europe is sleep walking to disaster with current policies on the Euro. The existing divisions will grow stronger and even if somehow Europe avoids a disorderly Italian exit from the Euro, the status quo is unsustainable. However, there is no public support to fully federalise public spending and taxation at a European level.
This dilemma is now focusing minds in Brussels and is likely to overshadow the closing stages of the Brexit negotiations. Europe could very well change substantially before the UK leaves. But in which direction no one knows. All that is clear is there is strong and growing determination in Brussels and Berlin to show that leaving the European Union or departing from the central orthodoxy carries a big price. That may work in the short term, but it is unlikely to work as a long term strategy for ensuring ongoing public support for the European Union around the continent.