Italy crisis: What triggered the political turmoil and how can it be solved?

Since at least the 1990s, voters have been turning to ever more populist and extremist parties

Italy's political crisis moved into unchartered waters on Wednesday, as the head of state sought a last-minute political compromise to end the three-month search for a government and restore calm to financial markets.

Here we answer how Italy arrived at a state of political turmoil and what can be done to fix it.

Why is there so much trouble in Italy?

The Italians are unhappy politically, and have been for some time. Italian governments have failed to meet the aspirations of Italians since at least the 1990s; and the voters have been turning to ever more populist and extremist parties as a result. The brief premiership of Matteo Renzi, which fell at the end of 2016 after he lost a constitutional referendum was probably the last gasp of conventional politics. A kind of Italian version of Tony Blair or Emmanuel Macron, Renzi's promising attempts at political and economic reform eventually stalled. His progressive/liberal Democratic Party secured a little over a fifth of the vote at the last election, pushed into third place the League (37 per cent) and Five Star (32.7 per cent).

So who are these new parties?

The two leading groups in Italy are now the Five Star Movement, which was, literally, founded by a comedian, and is a kind of Italian Ukip; and The League, formerly the Northern League, which enjoys most of its support in the wealthier north of Italy, rather than the poorer, more rural south. (Analogous to Catalan separatism in Spain).

The League advocated virtual separation for the Northern provinces to form their own state. Some seek outright independence, reversing the historic Resorgimento (unification) of 1861. The League is thus a kind of cross between the politics of the SNP and Ukip.

Why are they not the government?

The president vetoed their choice of finance minister because he was a eurosceptic and might seek to lead Italy out of the euro – for which the Five Star/League parties did not receive a mandate from the Italian electorate. The parties then refused to form a government, hence the stalemate. Some form of technocratic government will govern Italy until fresh elections are held. These may in effect become a referendum on staying in the euro (though not the EU).

What’s the problem?

Italy’s slow-growing economy means poorer public services, bigger national and private debts, lower wages and lower living standards than expected. Some blame immigration, and Italy is certainly the first destination for many making their way across the Mediterranean from Africa.

Some also resent the euro, the European single currency, fully adopted in 2002, and regard it as a German racket. On this reading of things, the Germans do well out of Italy by selling the Italians their cars and then lending the Italians the money to pay for them, a cycle leading to a sort of economic bondage.

Italians thus believe the EU, and Germany in particular, has too much power over Italy; hence the new strain of euro scepticism in what was traditionally an enthusiastic founding member (1957) of the European Union. Once the tacit admission in Italy was that they’d prefer Brussels to turn their affairs than Rome. That has now changed.

So the Italian populist parties are stirring up conflicts with the EU Commission in Brussels and the European Central Bank in Frankfurt – convenient scapegoats.

What’s gone wrong?

The Italian state and the Italian banks are going bust simultaneously, because they rely upon each other and neither is strong.

The banking crisis after 2008 exposed two particular Italian problems, apart from longer term demographic and industrial trends, and these are still the immediate issues.

First and most serious is the weakness of her banks. By tradition most of the debts issued by the Italian government were purchased by Italian banks, pension funds and other financial institutions. The Italian banks are therefore stuffed full of Italian government bonds, and investors are becoming increasingly concerned that the weaknesses in Italy's public finances, namely a very large national debt, would lead to a default on the bonds, leaving them less valuable or worthless, and destroying the financial assets of the banks – which would then suffer a run and go bust.

Italy and Italy’s banks would be insolvent – and beyond the capacity of Germany or the EU to rescue.

Only a huge programme of buying Italian government debts, via the Italian banks, by the European Central Bank, in turn funded by the German taxpayer, has prevented this collapse from happening sooner.

Since the banking crisis in 2008 the Italian has not developed as badly as the Greek one – but it is not entirely fixed either.

Now that there is talk about the ECB buying less Italian government debt the old worries about Italy are coming back. These are exacerbated by the populist programme of the Five Star and League parties – which would need to borrow much more in order to fund their ambitious spending programmes.

When did it go so wrong?

Dissolution with the post-Mussolini, post-Second World War settlement set in during the 1990s, when the old parties, the Christian Democrats and Socialists, became mired in scandal and associated with political and economic failure.

Italy’s economy had began to stagnate, losing its competiveness and compounded by a low birth rate and declining working population. The post-war boom, an economic miracle which had seen Italians moving from the countryside to the towns and cities, owning scooters and cars and growing prosperous was ending.

In the 1950s and 1960s Italy, carried along by the increase in trade in the original EU, was growing at 7 per cent or so a year. Names such as Fiat, Lambretta and Zanussi became famous globally powerful brands, along with luxury brands such as Prada, Armani and Ferrari.

But by the 1990s low growth, higher unemployment and stagnant living standards became the norm; increased migration, which might help the Italian economy if properly managed, was viewed with resentment and suspicion.

It was then that figures such as Silvio Berlusconi and his Forza Italia gained in popularity, themselves eventually giving way to Five Star and The League.

What is the answer?

If the economy, public finances and banks were fixed, many of Italy’s political problems would melt away. There are three options:

La Dolce Vita: Carry On Regardless

This would mean allowing a Five Star/League government to carry out its spending plans, allowing it to borrow and print much more money, and have the ECB buy all the resulting debt without complaint.

Italy would also be allowed to print a parallel euro currency of its own, as the populist parties would like, (“mini bonds”) to help fund its spending, any inflationary problems being dealt with by the ECB, again without penalty to Italy.

This would require the wealthier economies of Germany, the Netherlands and Finland, for example, to continue to subsidise Italy, in return for its continuing membership of the single currency and something resembling stability.

However the ECB has already indicated it wishes to scale back its purchases of Italian government debt – which has fuelled investors’ concerns that no-one else will buy them.

Exitaly: Italy leaves the euro

In the long term this would enable Italy to devalue its own currency to get through structural reforms, solve any problems with international trade and to accommodate inflation, as was traditional when they used the lira. It cannot do this under the euro, and instead has to cut public spending, cut wages and undergo austerity – all deeply unpopular.

However, bringing back the lira also means that interest rates would soar to persuade investors to take on the risk of a devaluing new lira currency or a default by an Italian government unable to pay back its treasury bonds.

In the short run, Italy's already large national debt would need to be redenominated in the new lira currency, which, being worth less than the euro, will make the debt more expensive to service, perhaps prohibitively so.

A European Risorgimento: Reform of the euro system: adding a banking union and a fiscal union

This is the kind of solution President Macron of France has been campaigning for. It would mean that all eurozone governments in effect take on each others debts, and all are responsible for the stability of the banking system in every member state of the single currency.

So this would include the likes of Greece, Spain and Italy, but not Sweden, Poland, Denmark, or the UK for that matter, who are not euro members.

There might be more pressure on the Swedes and others to join the euro to “burden share” the costs of the European fiscal union. It would also require a powerful central European finance ministry and chief.

The Macron reforms would work because any monetary union, such as the euro, will never work smoothly, or at all, without a corresponding fiscal union, and preferably banking union too.

However the objection is that it would require the transfer of huge sums from the richer northern economies (Germany especially) to the poorer southern ones (Italy especially), and a leap forward in political integration.

Angela Merkel has made plain her reluctance to take on such obligations; and, in parallel to Italy, extremist eurosceptic movements such as the AfD have been making progress in Germany at the expense of the traditional Christian Democrats and Social Democrats.

Germany, as much as Italy itself, may soon have to choose whether it still wants Italy in the eurozone.

Without Italy, the zone's third largest economy, though, the fundamental sustainability of the euro would come under question. Financial chaos could break out and, via “contagion” in interlinked banks and economies, spread through the wider European financial system and economy, with a global impact.

One side effect of that would be to make Brexit look somewhat more palatable to the British.