Argument

It’s Time to Choose Democracy Over Financial Markets

The Italian president's decision to reject an elected government makes neither economic nor political sense.

Figurines on an Italian flag, atop an EU flag. (Philippe Huguen/AFP/Getty Images)
Figurines on an Italian flag, atop an EU flag. (Philippe Huguen/AFP/Getty Images)

In the 20th century, when electoral results did not please the established elite and its international allies, tanks rolled down the street. In the 21st century, the reaction is less bloody, but no less intrusive. Rather than tanks, the bond market is used.

This is what happened in Italy last Sunday, when a government with a parliamentary majority was blocked by the president for fear of how the bond market could react to 81-year-old former Bank of Italy executive Paolo Savona, the designated economic minister. (Full disclosure: I was rumored to be in the running for the job, but was never offered it.) Savona’s crime? He had developed a contingency plan for an exit from the euro, in case it came to it. It was as if the U.S. president were to fire a defense secretary because they developed a contingency plan for a nuclear war with North Korea, when they would have actually deserved praise for their preparedness.

But let’s concede that the Italian president was right, that the appointment of Savona could trigger panic in the fragile Italian bond market. Let’s likewise concede that he had the constitutional power to do so. Should he have done it? Should the fear of markets overrule democratic decision-making?

Economists (including myself) generally love the efficiency of markets in allocating resources. Good economists, however, know that, to work properly, markets should be competitive and market participants should be equally informed. The market for sovereign debt in Europe satisfies neither condition. In a competitive market, each individual trader should be a price-taker — that is, their trading activity should have no impact on market prices.

But, by its own admission, the European Central Bank (ECB) has an impact on market prices. Otherwise, why does it engage in buying sovereign bonds to reduce their yield, a practice known as quantitative easing? Thus, the European bond market no longer aggregates the opinions of thousands of independent traders; it has become a beauty contest trying to anticipate the next ECB decision. In such a market, a declaration by an ECB board member that quantitative easing should end earlier than expected (as done Tuesday by Sabine Lautenschläger, a member of the ECB executive board) can be sufficient to spook the market and increase the spread between Italian and German bonds.

Is it wise to anchor political decisions in any other country to the whims of such a market? The Italian president evidently thinks so. But to do so is both economically and politically dangerous.

It is economically dangerous because educated economists know that the market for sovereign bonds can have multiple equilibriums. Thus, when the ratio of debt to GDP is high, a rumor is enough to move the bond market from one equilibrium to another, risking default. In general, this possibility is prevented by the domestic central bank. At the ECB’s creation, however, the necessary central-banking mechanisms were expressly not built in, in order to let markets impose discipline on member countries. But this was bad economics, guaranteeing the ECB would eventually have to actively intervene. The result for member states hasn’t been discipline by a properly functioning market, but by the ECB — an institution composed of individuals who, even if well meaning, are fallible.

Which brings us to the political dangers. Any institutional arrangement that gives a nonelected body like the ECB unchecked dominance over elected ones raises serious legitimacy questions. Imagine a hypothetical in which a comment by a German ECB executive accidentally started an unraveling in the Italian bond market, which forced Italy under a European Stability Mechanism-International Monetary Fund program. What kind of political legitimacy would such an outcome have in Italy? Even a country less fascinated by implausible conspiracy theories would start to suspect a German plot. This suspicion would become certainty if a German European commissioner were to declare that financial markets would teach Italians not to vote for populists. Fortunately, this latter point is also a hypothetical, though just barely: European Union Budget Commissioner Günther Oettinger this week said that he hoped “the negative development of the markets” provided “a signal to voters not to vote for populists on the right or left.”

Am I denying the rights of Italy’s European partners to be concerned about the budget full of promises (and no measures to pay for them) agreed by the Five Star Movement and the Lega? Absolutely not. I also empathize with the concerns of German Economist Hans-Werner Sinn about the so-called Target2 debt that Italy is accumulating through the euro system — debt that is the result of more foreign investors selling Italian bonds than buying them.

Both concerns, however, reflect fundamental design flaws of the euro. The state of Indiana is not concerned about the profligacy of the state of Illinois, nor of the debt that the Federal Reserve Bank of Chicago accumulates with the Federal Reserve System. Illinois is free to choose its governors without interference from Indiana (even if some fiscal conservatives would prefer otherwise), just as the state of Illinois is free to default without dragging down with it all its local banks and the entire local economy. The reason is that there are sufficient federal institutions, from unemployment insurance to deposit insurance, to absorb the shock. And there is a common political authority — specifically, the U.S. Congress, where smaller states are overrepresented — to settle any contentions that might arise.

Europe’s political tensions are thus not inevitable. The European common currency, however, was created ahead of the institutions necessary to support it. The hope — expressed openly by some Italian politicians — was that a crisis would eventually accelerate the creation of such institutions. But almost 20 years after the introduction of the euro and 10 years after a once-in-a-century economic crisis, the progress towards the creation of such institutions in Europe has been minimal.

Many Europeans disagree. They see the progress of the past decade as encouraging, especially as compared to the total stagnation of the euro’s first 10 years. Of course, if you are living on the top floor, building a pump to drain water does not appear as urgent as when you live in the basement. Italy is living in the basement of Europe, and it is drowning.

No Italian government can reform the Eurozone by itself. Yet reform will not happen without trying. French President Emmanuel Macron seems willing to spend some political capital go promote a reform of the eurozone, but he needs an ally in Italy — the economic zone’s third-largest economy — to likewise make it a priority. This would be the main benefit of a coalition between the Five Star Movement and the Lega. Both parties promised to fight for reform in Europe — a promise on which they bet their political future.

Rather than criminalizing pleas for help, Europe should roll up its sleeves and propose a plan for change. Otherwise, not just “il bel paese” — the beautiful country, as Italians like to call our homeland — will sink, but the very idea that the continent can live together in peace and prosperity.

Luigi Zingales is Robert C. McCormack professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business, and host of the podcast Capitalisn't. Its next episode will focus on Italy.

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