Renzi’s Great Gamble

Renzi’s Great Gamble

By Nick Andrews and Stefano Capacci
August 24, 2016

Prime ministers come and go in Italy – four since the financial crisis – but precious little seems to change. The latest incumbent, Matteo Renzi, has pursued structural reform more energetically than his predecessors. But for all the progress he has made, he might as well have been wading through molasses. Now, in a bid to secure a popular mandate for his restructuring program, Renzi has bet his premiership on a referendum over badly-needed constitutional reforms. It is a high stakes gamble.

If Renzi wins the vote, which is due in either October or November, his proposed measures will streamline Italy’s legislative process, breaking the parliamentary gridlock which has crippled successive governments, and opening the way to far-reaching economic reforms. If he loses, Renzi has promised to step down – a pledge that has turned the referendum into a popular vote of confidence in the unelected prime minister, his Europhile policies, and by extension Italy’s membership of the eurozone itself. As a result, a “No” vote in October will not just precipitate the fall of Renzi’s government; it could throw Italy’s long term membership of the eurozone into doubt, plunging the single currency area once again into crisis.

Policy no man’s land

Italy’s fundamental problem is that it is stuck in a policy no man’s land. Its old economic model, in place for much of the last three decades of the 20th century, relied on a combination of currency devaluation to maintain international competitiveness together with fiscal spending to support the poorer regions of the country’s south.

GK Italy DeVal

Signing up to the euro put an end to all that, preventing devaluations and prohibiting budget deficits at 10% of gross domestic product. However, the design of Italy’s bicameral parliamentary system, in which the upper and lower house – the Senate and the Chamber of Deputies – wield equal legislative power, made it almost impossible for any government to push through the structural reforms necessary for Italy to compete and prosper within the eurozone. The result has not just been depressed growth and relative impoverishment, but an outright decline in living standards, as Italy’s real GDP per capita has slumped to a 20-year low.

GK EZ Comps

Such a below-par economic performance has led to a build-up of bad assets on the balance sheets of Italy’s banks, where 18% of all loans are now classed as non-performing. In turn, this bad loan overhang has eroded the ability of the banking sector to extend new credit to the thousands of small businesses which are the engine of Italy’s economy and which normally power employment growth. The result is stagnation.

To stand any chance of escaping this low growth trap, Italy needs to enact wholesale structural reforms to enhance its competitiveness relative to its eurozone neighbors. Notably, it needs to make the labor market more flexible to encourage job creation, it needs to lower the barriers to entry that protect much of the country’s service sector, it needs to overhaul a judicial system so sclerotic that bankruptcy proceedings can last 10 years or more, and it needs to restructure its fragmented and dysfunctional banking system.

The prescription might be clear, but Italy’s political system makes enacting reform all but impossible. Renzi has already tried to overhaul Italy’s labor market by attempting to dismantle the generous protections that make it difficult and expensive for companies to dismiss staff, and which therefore encourage businesses to hire only temporary workers, heightening economic insecurity among the young.

But Renzi’s attempt ran into bruising opposition from Italy’s powerful and well-subscribed trade unions. The results were a watered-down reform package that entitles existing permanent staff to a near-guarantee of lifetime employment, and a severe dent in Renzi’s popularity from which he is yet to recover. It’s a familiar story in Italy. Entrenched interests, whether represented by local and regional political leaders, unions, protected professions, or established private sector companies, exert enormous influence over the political process. All profit from the status quo, which promises they will continue to benefit from special protections and payouts. And because of the equal balance of power in Italy’s parliament, which means the Senate can block government legislation indefinitely, the consequence is political – and economic – stagnation.

Bloated and wasteful

Renzi’s referendum aims to change that. The prime minister is seeking popular approval for constitutional reforms that promise to cut the size of the upper house from 315 to 100 senators. Under his proposals, senators will no longer be directly elected, but will instead be chosen by regional councils, nominated by the mayors of big cities, or – in the case of five – be appointed by the Italian president. The reform will not only cut the costs of the notoriously bloated and wasteful upper house, where senators have traditionally enjoyed lavish expenses and generous pensions. Most importantly, it will downgrade the political power of the Senate so that it will no longer be able to obstruct government legislation entirely, but only to propose amendments that will be adopted at the discretion of the lower house (although the Senate will retain a say on constitutional ma tters, including the ratification of European Union Treaties). The objective is to increase the executive power of the government, and to tackle entrenched interests with additional measures that allow for new laws to facilitate popular referendums and to promote citizen participation in the political process.

Unlikely alliance

However, powerful forces are arrayed against Renzi, and a “Yes” vote is far from assured. The proposed reforms have attracted opposition not only from establishment voices who benefit from the current arrangements. They have also drawn fire from constitutional lawyers and anti-establishment parties, including the populist 5-Star Movement, which argues the 50% simple majority needed to win the referendum is too low for constitutional changes that promise a concentration of political power unprecedented since the formation of the Italian republic in 1946.

Perhaps more importantly, Renzi’s pledge to resign in the event of a “No” victory has raised the possibility of a protest vote against the prime minister himself – the third unelected head of government in succession – from a broad cohort of the electorate which is thoroughly disillusioned with Italian politics. Increasingly disgruntled, these voters are sick of the corruption and self interest of politicians, and fed up with painfully austere policies that they believe to be dictated from Brussels and Berlin, and which they hold responsible for Italy’s poor economic performance.

The chances of a “Yes” vote in the referendum have not been improved by the slump in Renzi’s personal popularity following last year’s attempt to reform the labor market, and a series of small bank restructurings that saw retail savers “bailed-in” – forced to take losses – under new European Union banking regulations. From 40% after Renzi entered office two years ago with optimistic promises of reform, the approval rating of the prime minister’s PD party has fallen to little better than 30% today, much the same as that of the opposition 5-Star Movement. As a result, with two months to go the referendum is too close to call. Opinion polls indicate the “Yes” and “No” camps are running roughly equal, with a large proportion of voters still undecided.

GK Italian Options

If Renzi loses the referendum, not only will Italy remain in policy limbo, but it is highly likely his subsequent resignation will trigger a parliamentary election. Under new election laws passed last year, if a party fails to win 40% in the first round of voting, the top two parties go through to a second round. The latest opinion polls put Renzi’s governing PD party on 31% and the 5-Star Movement on 29%, with the next two largest parties – Silvio Berlusconi’s Forza Italia and the anti-establishment Northern League – level pegging on around 13%.

In recent years, Renzi’s PD government has represented the best hope for structural reform and economic modernization. But even if the PD party were to win a post-referendum election, there is a risk that, following Renzi’s resignation, the left wing of the party would wrest back control from the reformist center-right faction, damping hopes for further restructuring. Such a swing to the left would hardly be unique to Italy. In the UK, the militant left has captured the leadership of the main opposition Labour Party. In Spain, Podemos has split the left wing vote, and in France the ruling Socialists have come under pressure in the polls from the radical and Euroskeptic Left Party led by Jean-Luc Mélenchon.

GK Italian Polls

At the moment, an election victory for the 5-Star Movement, which identifies as neither left nor right, appears at least as probable as a second round win for the PD. The Movement has already scored significant victories in mayoral elections in Rome and Turin, and enjoys increasing support across the country. Its broad stance is anti-establishment and in favor of direct participatory democracy rather than representative democracy, which it regards – with some justification in Italy – as an invitation to corruption. Beyond that, however, its platform is so vague that it is hard to pinpoint any concrete policies, except its call for a referendum on Italy’s membership of Europe’s single currency.

Leadership vacuum

Perhaps the biggest problem for 5-Star, however, is that it has no clear leader. Its founder and leading voice, Beppe Grillo, was found guilty of involuntary manslaughter in 1980 following a fatal road traffic accident, and so cannot run for public office under Movement rules barring candidates with criminal records. Without Grillo the parliamentary party would be leaderless, meaning 5-Star has no obvious prime ministerial candidate even should it secure a majority in the election.

All this means that the possibility of a “No” vote in Italy’s constitutional referendum come October or November is the biggest clear and present danger to the euro’s survival. Both 5-Star and the Northern League are promising a plebiscite on euro membership should they come to power in a post-referendum election. That does not mean a vote on Italy’s eurozone membership would lead directly to its exit – many likely “No” voters in this year’s constitutional referendum favor continued euro membership. However, a “No” vote come October would effectively be a vote against the structural reforms needed to ensure Italy’s economic growth and prosperity within the eurozone.

In other words, in the event of a “No” vote in October, the only economic choice for Italy would be between continued stagnation, or a return to the old economic model of successive devaluations. The latter course would naturally mean exiting the eurozone anyway. But even if Italy were to take that path, it would hardly be a less painful way to restore the economy to health. Whether inside or outside the single currency, Italy still needs structural reform to ensure future growth. The only potential benefit to leaving the eurozone would be that deep devaluation of a reconstituted lira could help to ease some of the transitional pain (although it is probable the palliative effect would be more than offset by the additional economic and financial damage wreaked by an exit).

Europe in microcosm

Clearly investors should be concerned. Italy is the third biggest economy in the monetary union and one of its core members. Its departure would surely hasten the break-up of the whole euro project. What’s more, the political and economic tensions within Italy ahead of October’s referendum mirror those at work across the eurozone as a whole. In Italy the wealthy north makes up the industrial heartland which drives the economy, while the south is underdeveloped and poor. There is little enthusiasm for structural reforms, and throughout the country populist movements which promise to tear down the self-serving political establishment are rapidly gaining ground.

Italy is the wider eurozone in microcosm. In the EU as a whole, progress towards creating the political and economic institutions that could ensure the success of the single currency project have been comprehensively obstructed by narrow – but deeply entrenched – national interests. This failure to advance, and the economic hardships and sense of disempowerment that have resulted, has fueled the rise of populist political parties from Greece to Finland – parties that are challenging an increasingly distrusted political elite and questioning not just the status quo, but the whole European project. If Renzi wins come October, the eurozone has fresh hope. But if he fails, Italy fails, and very likely the eurozone fails too.

 

Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting http://www.mauldineconomics.com.

To subscribe to John Mauldin’s e-letter, please click here:
http://www.mauldineconomics.com/subscribe

Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium W ave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining the Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at www.MauldinCircle.com or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Mil lennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have t otal trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.


This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results. Trading advice is based on information taken from trades and statistical services and other sources that Commodity & Derivative Advisors believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades.