A View from Europe: Monetary policy, structural reforms and the rise of populist politics

*This BBL Seminar is NOT for Quotation.

Date October 25, 2018
Speaker Paola SUBACCHI (Senior Research Fellow, Global Economy and Finance, Chatham House)
Moderator TSURUDA Masanori (Director, Europe Division, Trade Policy Bureau, METI)

During the brown bag seminar I will presenter an overview of the key trends in Europe and will discuss the announced shift in the monetary policy by the ECB. Against this background I will look at the rise of populist politics - the UK, Italy, Hungary - and present the risks for financial stability in case of a no-deal Brexit and Italy's higher costs of managing its debt.



Paola SUBACCHI's Photo


In this talk I will give an overview of the situation in Europe and elaborate on the state of Brexit and the budget of the Italian government in relation to the European Union.

Brexit, the United Kingdom's departure from the EU, began with the referendum held in June 2016 and continues to this day. The UK officially began negotiations with the EU in March 2017. Italy's populist government has also challenged the EU with a budget that does not encourage economic growth. These two main concerns fundamentally challenge the European Commission. Considering the size of Italy's public debt, a sovereign debt crisis would cause untold damage.

The regional differences within Europe can challenge the sustainability of the European project; some even talk of a two-tier Europe or the splitting of Europe. Europe is behind the United States's business cycles. The euro is currently weak against the dollar, and business and consumer confidence is weakening; possibly resulting in slow growth. In spite of the differences, Europe retains hope through good companies and innovation.

The outlook for Europe

The euro area lacks growth, as it is still recuperating from its losses during the financial crisis. From closer inspection of the figures that we have (which are at the macro-level) we see that some countries have not recovered - such as Greece and Italy. Greece's economy has finally seen strong growth since its financial crisis in 2009-2015, whereas Italy is still behind. Italy has experienced sluggish growth for the past 20 years. This is a matter of concern, particularly because of its ageing population and public debt levels.

U.S. business and monetary policy cycles

Compared to the euro area, the U.S. is more advanced, both in terms of business cycles and monetary policy cycles. While income per capita in the euro area has been struggling since the global financial crisis, the U.S. has embraced normalisation of monetary policy. Europe adopted quantitative easing (QE) much later than the U.S. and still remains in this cycle. The European Central Bank (ECB) has said that they might stop purchasing at the end of the year depending on the Italian situation, as the ECB QE has had Italy managing large issuances of sovereign bonds. There is no plan, however, for the ECB to raise interest rates.

The UK, on the other hand, has changed its interest rates and it is struggling. Brexit is a process, not a single event like the referendum, and as such it is more likely to affect currency. Indeed, Brexit's biggest impact has been on currency, not on its gross domestic product (GDP) growth. Even though all forecasts suggest a considerable slowdown in growth, putting the UK growth rate in the context of similar advanced economies, it is not as bad as some predicted. Although the currency is weak, and the Bank of England is concerned about the situation; we have not yet seen a significant fall.

The UK has a large current account deficit, so capital inflows and a healthy financial sector are essential to maintain an appropriate balance in the economy. There is a lot of discussion about whether the weakness of sterling is temporary, or whether it will stay permanently at this level due to the potential persistent loss in growth resulting from a "hard Brexit," which is a Brexit without a deal with the EU.

Building pressure?

Comparing the regional differences across European states by output gaps, the positive gaps, closed gaps, and small negative gaps can be seen - with the exception of Greece - with a significant negative gap, due to its long crisis and long recession. Focusing on the eastern-central European countries, Poland, Hungary, Slovenia, and Slovakia, all have positive gaps. Germany, Spain, Portugal and the UK, on the other hand, all have closed gaps. Considering that Spain and Portugal have experienced difficulties during the sovereign crisis, they have recovered quite well. Ireland, with a positive gap, was first to recover from the global financial crisis, and its economy has since been quite strong. France and Italy, which are two of the major economies in the European monetary union, have small negative gaps.

What this data indicates is that there is difference in the speed of recovery within Europe. Due to those differences, there are political pressures and tensions within the EU, including the emergence of euro-skeptic populist politics. It is also very difficult for the ECB to decide its monetary policy, especially governing interest rates.

Not enough resilience

We have built a lot of resilience in Europe after the crisis, which is crucial for making external and internal adjustments. Some countries have managed to build resilience and stronger economies, however, as the EU was not good enough. External demand has driven growth in Europe and helped in getting out of the crisis. Although a lot of countries were able to recover the losses from the crisis, not all the EU countries have been successful. An additional problem across Europe is productivity growth; from the UK to Poland, they all struggle to make internal adjustments. Unemployment and underemployment also stirred discontent, along with migration.

A stronger external position, but not for all

Out of the entire EU, Ireland has the largest current account surplus in terms of GDP; a complete turnaround from pre-crisis conditions. The Netherlands and Germany both had a current account surplus before the crisis, which is currently increasing. Those are the countries which have benefitted from exports and internal economic adjustments. Italy has improved its position, as it had a small deficit before the crisis, but now has a small surplus. It has a strong manufacturing centre and is an exporter, though its difference from the above-mentioned countries can be attributed to the collapse of domestic demand and its impact on import. Spain had a large current account deficit before the crisis, but now it has a small surplus. It managed to cover the losses, has strong economic growth, and has made improvements in the banking sector. On the other hand, the UK still has a large current account deficit, which has not improved since the crisis. It has gone through a financial crisis and banking problems, and its level of debt is still high. This is a matter of concern in view of Brexit and the current weakness of sterling.

Productivity growth is key to adjustment

Furthermore, Europe faces productivity problems in labour and total-factor productivity. In terms of total-factor productivity, some countries in Northern Europe are quite good at growth, but labour productivity is problematic; and labor productivity is linked to wages. Immediately after the crisis, nominal wages went up and remained constant, before starting to fall. This means that the process of economic adjustment in the post-crisis period began only a few years later and then continued. Now we are at a point where the real wage level, relative to productivity, has returned to the same level as 2005-2008. Unemployment is only 0.5% higher than it was in 2005-2008; it is positive in economic terms, but it is problematic in social terms. Europe as a whole has been growing, but not outstandingly well, which means these problems are in the areas where growth is sluggish. In those areas, as it is difficult to adjust wages in the labour market to increase productivity, other adjustments are made: unemployment and underemployment. The unemployment rate has improved drastically, but it remains high in so-called "southern countries" and in the younger generation. In addition, the number of underemployed and part-time employment is increasing; as a way to cope with collapsing domestic demand, companies have implemented job-sharing. There is no change in the way people work, and people have flexible working arrangements, but this ultimately is a cut in wages. Italy, Cyprus, and Spain are the countries that have increased involuntary part-time employment the most, and they are much more vulnerable to populist politics.

What's next?

The concept of resilience is important in a monetary union. In particular, I am referring to the monetary union, because some parts of the EU are currently vulnerable. As making adjustments to the nominal exchange rate is difficult, the level of domestic prices is important. Wages are therefore important in terms of maintaining competitiveness; wages and flexible labour markets are essential, and structural reforms should go towards this direction. Productivity is also crucial to maintain wage growth. Countries that find it difficult to grow at steady rates find it difficult to maintain balance in the labour market. The result is that the number of people at risk of poverty has increased across Europe, within some specific areas in Italy, Greece, parts of Spain and parts of Portugal. Spain and Portugal are doing better in terms of growth, but in countries like Italy and Greece, it has become almost endemic. The data from the European Commission suggests that the amount of people in Italy at risk of poverty, is almost 25% of the total population.

Migration has become a political issue

In addition to this, the influence of migration has created tensions, and is itself becoming a political issue. You can see a big increase of migrants, in particular from countries outside the EU. Free movement of people inside the EU is one of the pillars of the single market. The skilled labour of EU nationals tend to move towards the northern countries as a result of the crisis, meaning that the southern countries suffer the most. This has become a problem because now there is an imbalance in skilled labour. Countries with more dynamic economies tend to attract people with the best skills.

Migrants from outside the EU have become a political problem, starting in 2015 when there was a spike in the number of refugees trying to come to Europe through the Mediterranean Sea. Responding to humanitarian crisis around the world, Angela Merkel stated publicly that Germany was happy to welcome 1 million refugees - which became a significant political problem for her. The recent election result in Bavaria is an indication of the fact that it was probably the right thing to do from a humanitarian standpoint, but it was not something that voters wanted to see.

Migration has become a political issue for a number of reasons, because the EU was not able to develop a coherent and consistent policy of how to manage the inflows. The problem was pushed onto North Africa and a clearance point was built there, but the problem has not been solved. Migration was the key issue in determining the outcome of the Brexit referendum, too. At that moment, the whole debate shifted to migration. However, the issue was confused because the political messages did not distinguish between migrants from inside and outside the EU. Nevertheless, this shift away from parliament, red tape and sovereignty, to migration, became a stronger selling point for the candidates who promoted leaving the EU. This was the same in other countries - for example in France, the election focused on migration. The focus on migration was not only to protect jobs and the state of welfare, but also to protect identity. It is now a big issue in Hungary and Poland as well. In Hungary they are very clear that they don't want any migrants, and are closing the border. France and Italy are at odds over their border, where controls have been reinstalled due to the lax restrictions of the Schengen Agreement, allowing illegal immigrants to move freely through countries.

Threats to the EU

Tensions in adjustments, labour market problems, divergences in terms of growth, and populist politics, all conflated together to create a situation where many countries are more critical towards the so called constraints imposed by the EU, despite the fact that these constraints are part of the collective decision-making process. Italy is the first country to openly challenge the European Commission. It claims they need to spend more money to help the economy. This, I believe, is based on a false premise. Italy is a country under stress, but this is because, at the time of the sovereign crisis, there was no clear idea of constraints and obligations in terms of policies that came from being part of the monetary union. By being a part of the monetary union, it had to give up its currency, which means to forgo the ability to use exchange rates, active currency policy, and monetary policy. Italy used to have regular devaluations in its currency to maintain competition in exports, but this is no longer available. What it needs is structural reform, a flexible labour market, and the ability to complete through strong productivity growth. Germany, by luck or design, managed to refurbish and rebuild their economy in the beginning of the 2000s. In 2002-2003 Germany was struggling in the monetary union. The high exchange rate and the legacy of East Germany contributed to this. It was called the sick man of Europe at that time. Germany enacted wage controls and organised the labour market to get to its present condition. This doesn't mean that Germany doesn't have any problems; in fact, Germany is too strong. Germany should lend a hand to other countries if it is concerned about the sustainability of the monetary union. It is also true that the other countries should have done better at reforming their economies.

Back to Italy. The problem with Italy is not the fact that there is a need for more spending. There is, however, a need for a more active fiscal policy that actually helps the economy to grow. Italy gives more money to pensioners and young people, but this is not spending that helps the economy. In fact, it is spending that causes more problems. It creates a culture of dependence rather than a more dynamic economy.

The EU recently rejected a member state's budget for the first time since it was established - Italy now has a few weeks to reformulate its budget. Currently the government's approach is confrontational, because it is directed at the domestic constituencies. And this is because the next election is the European election in May next year. Both parties in the Italian coalition have their eyes on increasing the number of votes to solidify their position. The European Commission is careful not to challenge Italy openly as they know it will be used to fuel criticism for the EU, in particular the euro.

Wider risk premiums threaten the euro

Markets are getting nervous. There is an increase in risk premiums between Italy and Greece. The spread of Italian debt is now approaching Greek debt. Their nervousness is because this kind of economic policy is not sustainable; if it is pushed to its extremes, there will be an impact on debt sustainability. Calculations show that Italy can reduce its public debt. However, given the GDP and ageing population, what it requires is a primary surplus of 4.5%, which is considerable. In the past, Italy has managed to increase its primary surplus although not to this level. Essentially the primary surplus of the last few years has allowed Italy to maintain and stabilise the debt at 130% of GDP, which is not a bad achievement given the level of growth. With the current budget, the primary surplus would be halved, from almost 2% to 0.8% which means the debt would start to tear. If this is protracted it will be much more difficult, and the debt will increase. This is the situation that worries markets, and markets have attached a higher premium to Italian debt.

To wrap up

The bottom line is that there will be a compromise. But there will also be another Band-Aid measure, which will not really address the fundamental issues in Europe and which will actually, once again, push aside the key issues of reform of the EU. The EU would be viable if it can be reformed and more integrated; and address some of the constraints we have at the moment. In particular, the big constraints are the imbalances and asymmetry in the deficits and surpluses between the countries. Up until now we have been in an emergency state where reforms have not been able to be addressed. Because there is a political premium for those who openly challenge the EU, it becomes increasingly difficult to find positive developments.

In the meantime, the global outlook becomes increasingly challenging. With the debt-GDP ratio, the global monetary policy, and global financial instability, the outlook for Europe is far from reassuring. Some countries are still grappling with low growth and unemployment, leaving limited scope for fiscal policy, and threatening the integrity of the monetary union. A hard Brexit could undermine growth in the next few years and start to create problems inside the EU. The thing to watch in the months ahead is the European election in May 2019 because this will really give the sense of the future of the EU.


Q1: Regarding structural reforms needed in Italy and Germany etc., what is the best case and worst case scenario for the future growth and integration of the EU as well as the monetary framework?

The baseline scenario is being muddled through, and this will continue indefinitely as there is no appetite to enact reforms. The worst case scenario involves the two points of pressure: Italy and the UK. Brexit remains unresolved, notably because of the intricate political issue of the Irish border. Trade and economic issues can be solved because Teresa May's current plan focuses on goods and services. The border, however, is a more significant problem, with actors holding rigid positions. A hard Brexit would create a potential shock from an economic point of view, but also another shock for the EU. Italy will not help either; this could start us down the path of disintegration of the EU.

Even worse, is the possibility that Germany and the other northern countries will leave the European monetary union and continue on their own. Effectively, that was the situation before, as the Netherlands and Denmark were both previously pegged to the Deutsche Mark. Subsequently, Italy would be "the next Argentina" if it leaves the monetary union. As such, Italy would no longer pose a threat for German exports. This is the worst case scenario, but the probability of it occurring is low.

The best case scenario is: we get over populist politics through a progressive alliance across Europe. Emanuel Macron is considered to be the avatar of the EU. Domestic adjustment of countries in the monetary union is as important as external adjustment. We cannot ask Germany to be more fiscally lenient if Italy cannot be more disciplined. I hope we get through this phase and find a way to keep Europe together.

Q2: Japan had a long period of economic stagnation, however it enacted monetary policy, fiscal policy, and structural reform. In the case of Italy, monetary policy is decided by the ECB and fiscal policy is restricted. Pursuing structural policy without significant support of monetary policy and fiscal policy would be very difficult. As a result, many Italians have chosen populist parties. Germany can help as it has a large current account surplus, but at the same time the unhappy Italians must be encouraged to change their mindset. Do you see any solution addressing those unhappy Italians who have elected this populist government?

Japan has less restraints regarding monetary and fiscal policy so it was able to implement structural reform. Monetary policy is not an option inside the monetary union. Fiscal policy is constrained because if a country has a large amount of debt as Italy does, it must be constrained, even if the fiscal policy was in the hands of the national government. Italy's governmental institutions are the problem. It is a country which needs development and growth. It is a dual country, geographically speaking, in which the south has a huge problem. I do not advocate a split as Lega Nord previously hoped. I do, however, advocate a strong development policy for the south. This has never happened. There is dependency and a lot of problems, including criminality. The situation has deteriorated significantly in the last 25 years.

Before the 90s, Italy and Japan had a similar political structure - they experienced political instability but a steady state, as the governments were of a similar sort. Italy's populism predates Trump with Berlusconi; a tycoon with dodgy strategies, using the political system for business gain, plagued with judiciary problems, but charismatic, and with a direct message. He did extremely well and proved popular, acceding to Prime Minister with no political party backing and being self-funded. The result of this undermined governmental institutions due to the conflict of interests of a Prime Minister with a large television network. He never separated his own business and the role of Prime Minister. Then there was escalation, such as fiscal tax amnesties which lead a large capital outflow of money by the Italians. His message was very clear; you are allowed to do as you like. These factors undermined institutions. The point is: how do we rebuild them? In terms of public spending, there is a lot that can be achieved through saving and efficiency. The parallels with Argentina are of concern. Northern Italy, however, is very successful with some of the best companies in the world, those of which compete and collaborate with Japan. Japan, Germany and Italy share a lot of similarities in terms of being first class in the automobile industry, but the rest of Italy detracts from this. Unfortunately, I do not have an answer for your question. However, the populists only have roughly 50% of the power so the situation is salvageable. The populist message on immigration and controls is very strong while there is no strong political message in democratic progressive politics. Economic growth is essential, though lacking.

Q3: Do you have any positive elements? Italy has competitive industries in automobile and aircraft, and Germany and France are also the world leaders in industries. Given the long history of the European project, you have always overcome various crises. This time you may overcome the crisis again. What is your observation regarding this positive view?

The final point will be the European election. There are many parties critical of the EU, from Hungary to Spain, running in this election. Do not forget that the parliament determines the next European Commission. This would be disastrous if these EU critics would be inside one of the most important institutions. It is, however, also possible that this is a good moment to think about the EU. People may vote in the election, especially, those who were apathetic towards the European parliament before. That could support the European project. The younger generation has stronger positive views about the EU. Previously being apathetic towards the Brexit referendum, now the youth realise the benefits of the EU. As it has been said, growth is crucial. The EU is predicated on the idea that being together would bring benefits, without focusing on other aspects such as security, environmental standards, etc. However, it simply did not deliver these benefits, which helps explain people's unhappiness. The crux of the issue is to understand why we need to be within Europe and why not without.

Q4: What is the implication of the recent government debt issue to the banking system in Italy? The situation in Italian banking is bad. While this has improved slightly, there still are many problems. How do you see the implication of this recent government debt issue in Italy toward to the Italian banking system as well as other European banking systems?

The situation in the Italian banking system has improved substantially. The worst offender is Monte dei Paschi, which is better than it used to be. However there still is a large amount of non-performing loans which needs to be reduced, especially when compared to the growth rate of the economy. These non-performing loans remain on the books and cannot be recognised. There are many small banks in Italy, which in principle should merge. However because of these non-performing loans, all activities are constrained. As such, the situation is still uncertain. Having public debt in the books of the banks is not good. These depreciated assets affect share prices and may require the recapitalisation of some banks. And again, at this time, it is very difficult to go to the market. On top of this everything is more expensive. The Italian companies are penalised vis-à-vis the German companies in terms of high costs of borrowing, and of course this cost is increasing. This is an issue the current government does not understand.

*This summary was compiled by RIETI Editorial staff.