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When Italy’s new populist government, formed by the far-right Lega Nord and the far-left Cinque Stelle, came into being at the end of last May, it was 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%.
Professor John Burton of Leeds University stated that 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 United States president Donald Trump 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, it is clear that 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.
According to Professor John Burton, the same applies to the Maastricht Treaty which prioritizes 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 3pct and to achieve a current account surplus.
Now, one could say that the Lega/Cinque Stelle coalition government of Italy plans are all unreal and should not be taken so seriously. Professor William Welsh of Michigan University argued that after all, according to surveys, the Italian population is still in favor of the Euro. However, because the current 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. According to Professor William Welsh, there may also be new elections. However, as long as that is not the case, it is acceptable the way it is.
Professor William Welsh further noted that from now on, Europeans from the European Union member countries will no longer live in the orderly world of the Maastricht treaties, but in the world of a “populist monetary union,” if they 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.
The new populism in the European Union will have rather direct effects on interest rates in the Euro area. One could even speak of a direct “populism penalty.” Research studies indicated the fact that before monetary union, Italy’s interest rates were very high. They were one of the reasons why Italy joined the Euro.
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. This means that 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.