Italy, Spain: Two New Governments Threaten the Eurozone's Stability

4 MINS READJun 1, 2018 | 14:45 GMT
The Big Picture

Italy and Spain are the third and fourth largest economies in the eurozone, respectively, which means that political and economic turbulence in Rome and Madrid can have an impact on the entire currency area. In our annual forecast, we said the Spanish government would be weak, and that Italy presented the main source of risk for the eurozone. Both countries appointed new governments on the same day, introducing challenges that align with both our assessments.

What Happened

After a week of political turbulence, Spain and Italy have new governments. On June 1, the Spanish parliament voted to oust conservative Prime Minister Mariano Rajoy and replace him with Socialist leader Pedro Sanchez. A few hours later, Italian law professor Giuseppe Conte was sworn in as Italy's prime minister to lead a government that includes the anti-establishment Five Star Movement and the right-wing League. The government will be confirmed by confidence votes in Parliament next week.

While these developments offer some clarity about the future of two key members of the eurozone, they also serve as evidence that the new governments in Madrid and Rome have a very hard task ahead.

What's Going on in Spain

Spain's political crisis began on May 25, when a court convicted several people connected to Rajoy's Popular Party of corruption. This motivated the Socialists, Spain's main opposition party, to trigger a no-confidence motion against Rajoy. The Socialist strategy succeeded, paving the way for Sanchez to become prime minister. This, however, does not represent the end of the political turbulence in Spain. The Socialists control only 84 of the 350 seats in the Congress of Deputies, which means they will need support from several other parties to pass legislation. Moreover, Sanchez became prime minister with support from parties with very different interests, including Catalan separatists, Basque nationalists and the left-wing Podemos party — hardly a stable alliance.

In the coming weeks, Sanchez will attempt to move ahead with his political agenda, which includes reversing some of the austerity measures introduced by Rajoy and opening a dialogue with Catalan separatists. Spain's macroeconomic situation is much stronger than it was five years ago: the country's economy is growing, its fiscal deficit has been reduced and its banking sector has largely been restructured. In a speech on May 31, Sanchez promised to respect the budget for 2018 that was approved by the outgoing conservative administration. Additionally, the largest parties in Spain's legislature are pro-European Union, and there are no serious discussions about challenging the bloc.

However, the new minority government is weak and will ultimately struggle to introduce additional reforms to make Spain's recovery sustainable. And since many in Spain's parliament appointed Sanchez only to remove Rajoy, his government will face constant pressure to hold an early election.

What's Going on In Italy

The stakes for Europe are much higher in Italy, where the new government has openly pledged to challenge the European Union's fiscal rules. While the Five Star Movement and the League have significantly toned down their anti-euro rhetoric, their plan for the economy, which includes tax cuts and spending hikes, will be expensive and raise questions throughout the bloc about Italy's fiscal balance. Italy will demand that the European Union provides both more room for spending at home and greater public spending at the European level. It will also seek Southern European support in challenging Northern Europe's fiscally conservative positions.

Of course, the Italian government will be dealing with its own internal contradictions, as the Five Star Movement and the League have different interests and respond to different electorates. This discordance will make it almost certain that Italy will not obtain everything it wants from the European Union. But even so, the new government in Rome will be a disruptive force in European politics.

How Do These Events Impact the Eurozone?

Various financial markets' initial reaction to events in Italy and Spain was negative; borrowing costs for both countries rose and their stock exchanges faced loses. Worry over the impact of changing Spanish and Italian governments went beyond the countries directly involved, as the Greek government expressed concern about how the instability could impact Athens' plans to return to financial markets after the end of its bailout program in August.

Markets calmed down as the new governments settled into place. But the week's events were a reminder of the extent to which the eurozone is interconnected, with uncertainty in one country raising questions about the sustainability of the entire system. Considering the challenges facing the new governments that were appointed today, more political turbulence is on the horizon for the eurozone.

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