On December 4, Italy holds a referendum that would give sweeping powers to the winner of an election. If the referendum fails, prime minister Matteo Renzi has repeatedly threatened to resign.
On December 5, it is increasingly likely that Europe could wake up to an immediate threat of disintegration.
Münchau: After Brexit and Donald Trump, prepare for the return of the eurozone crisis. If Matteo Renzi, Italian prime minister, loses his constitutional referendum on December 4, I would expect a sequence of events that would raise questions of Italy’s participation in the eurozone.
Mish: Questions about Italy’s participation in the eurozone do not go away if the referendum holds. Questions last at least until the next election.
Münchau: The underlying causes of this extremely disturbing possibility have nothing to do with the referendum itself. The most important was Italy’s economic performance since it adopted the euro in 1999. Total factor productivity, the portion of economic output not explained by labour and capital, has fallen in Italy by about 5 per cent since then whereas in Germany and France it went up by about 10 per cent.
Mish: The underlying cause of this mess is the euro itself and the treaty that created it. Productivity is certainly to blame, but the treaty did nothing to alleviate productivity problems, instead it enhanced such issues. A single currency and a single interest rate structure was bound to increase tensions, and it did.
Münchau: The second source was the failure by the EU to construct a proper economic and banking union after the eurozone crisis of 2010-2012 and to impose austerity instead. If you want to know why Angela Merkel cannot be the leader of the free world, look no further. The German chancellor could not even lead Europe when it mattered.
Mish: Merkel has certainly blown it in a number of ways: on Greece, on a banking union, on Russia, on refugees, on punishment of the UK following Brexit. Münchau may not agree with all of those, but he does agree with some of them. Her policy of blowing in the wind on some issues, but remaining steadfast on refugees is directly behind the rise of the eurosceptic, anti-immigration AfD party.
Münchau: Italy has three opposition parties, all of which favour exiting the euro. The largest and most important is the Five Star Movement, a party that defies the usual left-right classification. The second is Forza Italia, Silvio Berlusconi’s party, which has turned rabidly anti-euro after the former prime minister was forced out of office in 2011. And the third is the separatist Lega Nord. In democratic countries, it is common that opposition parties eventually come to power. Expect that to happen in Italy too.
Mish: No disagreement. That is why I stated the coast is not clear even if Renzi pulls a rabbit out of his hat and wins the referendum.
Münchau: The referendum matters as it could accelerate the path towards euro exit. If Mr Renzi loses, he has said he would resign, leading to political chaos. Investors might conclude the game is up. On December 5, Europe could wake up to an immediate threat of disintegration.
Mish: No disagreement.
Münchau: In France, the probability of a presidential election victory by Marine Le Pen is no longer a remote risk. Of all the candidates that have declared, she is the best prepared. There are some who could beat her, like Emmanuel Macron, the former reformist economics minister, who declared his candidacy on Wednesday. But he may not make it to the final round of the elections as he lacks a party apparatus. If Ms Le Pen became president, she has promised to hold a referendum on France’s future in the EU. If that referendum were to lead to Frexit, the EU would be finished the next morning. So would the euro.
Mish: The only candidate Marine le Pen might beat is current president Francois Hollande who has an amazingly low approval rating of just 4%. Polls suggest anyone else would beat her. But we have seen how far off polls can be. I agree with Münchau’s key point: after Frexit, “the EU would be finished the next morning. So would the euro.” There are other match-ups that will cause the EU to lose something, no matter who wins. For details, please see Another One Bites the Dust: Sarkozy Outed in First Round of French Elections.
Münchau: A French or Italian exit from the euro would bring about the biggest default in history. Foreign holders of Italian or French euro-denominated debt would be paid in the equivalents of lira or French francs. Both would devalue. Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.
Mish: I have written about Target2 cascade implications of a large country leaving the eurozone many times. Germany will pay, one way or another. The best solution actually, which Münchau failed to mention, is Germany leaving the Eurozone now.
Münchau: Can this be prevented? In theory it can, but it would require a series of decisions taken in time and in the right sequence. For starters, Ms Merkel would have to accept what she refused in 2012 — a road map towards a full fiscal and political union. The EU would also need to strengthen the European Stability Mechanism, the rescue umbrella, which is not designed to handle countries the size of Italy or France.
Mish: Merkel may not be around. It is by no means certain that she wins the next German election. Then, even if Germany agrees to a transfer union, so would Finland, Austria, etc., etc.
Münchau: Think about it this way: if you ask the German chancellor whether she wants commonly-backed eurozone bonds, she will tell you no. But if she has to choose between eurobonds and an Italian exit from the euro, her response may well be different. The answer will also depend on whether you ask before or after the German elections next autumn.
Mish: I agree that Merkel will lie, then bend if necessary. But it is not her decision alone. The German constitutional court would have a say. So would other Eurozone countries. And, as I said, Merkel may not even be around.
Münchau: My central expectation, however, remains not a collapse of the EU and the euro, but a departure of one or more countries, possibly Italy, but not France. In the light of recent events, my baseline scenario is now firmly on the optimistic scale of reasonable expectations.
Mish: Münchau is indeed on the optimistic side. But note that his baseline scenario now includes several countries leaving the Euro.
Above emphasis in italics was mine in all cases.
A piecemeal disintegration of the Eurozone is now obviously very realistic. It was my baseline scenario all along.
For a detailed discussion of why Germany is a guaranteed loser no matter what happens, and why blaming Greece and Spain (Speece) is the wrong thing to do, please see Virtues of Germany vs. the Vices of Greece; What About “Speece” and Gold?
The fundamental flaws of the eurozone, including Target2, all but guaranteed a destructive breakup. See above link for details.
Mike “Mish” Shedlock