The markets have reacted well to the news that Mario Draghi has been tasked with forming a new government. It is hard to think of a better candidate to lead Italy through a crisis, but we doubt that he would have as transformative an impact on the Italian economy as he had on the ECB.
- The markets have reacted well to the news that Mario Draghi has been tasked with forming a new government. It is hard to think of a better candidate to lead Italy through a crisis, but we doubt that he would have as transformative an impact on the Italian economy as he had on the ECB.
- It is still too early to know whether Mr Draghi’s attempts to build a coalition will be successful, but it is clearly worth thinking about what might happen if he manages it. In this Update, we offer tentative answers to five key questions about a Draghi-led government.
- How would a Draghi government be different from the Monti administration in 2011? There are a few similarities between the two: on both occasions, following the resignation of the prime minister, the president asked a non-politically aligned figure to form and lead a new government through a crisis.
- But the differences are arguably greater. The first is that Mr Draghi’s cabinet might not entirely consist of technocrats, as the major parties are reportedly pushing for a mix of technocrats and politicians. This would give the government greater political legitimacy and might give it a longer shelf life than Mr Monti’s 16 months. The second difference, which may be more important for the economy, is that a Draghi government would not be tasked with imposing austerity. The backdrop to this crisis in entirely different to what Mr Monti faced, with sustained stimulus needed to the see economy through the pandemic.
- What would happen to fiscal policy? In his final months as ECB President in 2019, when euro-zone growth was slow but before the pandemic had begun, Mr Draghi pushed for governments “with fiscal space” to implement stimulus, while he said that countries with high debt should pursue “prudent” policies. Italy today arguably falls into both of those categories as its debt is high, but the low level of yields has provided additional fiscal space. Given that there is not a lot more the ECB can do to loosen financial conditions, and that Italy has implemented a lot less fiscal stimulus than advanced economies outside the euro-zone, Mr Draghi may want to increase the government’s fiscal support.
- What would Draghi do about the Next Generation EU funds? Given his experience, and the fact that he is (probably) not going to seek re-election, Draghi would be unlikely to push for the money to be spent on short-term giveaways that would be rejected by the EU. Italy could receive funds equivalent to nearly 12% of 2019 GDP spread over 6 years, of which just under 5% of GDP are grants.
- That said, he would not make the spending decisions alone, and some of the extra money from the EU might simply fund spending that would have taken place anyway. What’s more, given that Italy scores poorly in international rankings of government effectiveness, even the best laid plans could go awry.
- Would Draghi manage to implement structural reforms? During his time at the ECB, he repeatedly called for structural reforms across the euro-zone to boost productivity and reduce structural unemployment, and Italy needs faster productivity growth more than just about any euro-zone country. (See here.)
- However, his chances of implementing meaningful reform would depend on how strong the government was and how long it was likely to last. Reports have suggested that Lega leader Matteo Salvini has considered supporting Mr Draghi as long as a general election is held next year, which would give the government little time for reforms and might mean it focuses on the Next Generation EU priorities of digital and green investment, rather than longer-term problems such as simplifying the legal system and improving public services, or more politically contentious issues such as labour and pension reforms. Even a longer lasting government would struggle to make wide ranging and substantial reforms.
- What would all of this mean for Italy’s bond yields? Mr Draghi’s success would remove the risk of an election in the first half of this year that polls suggest would be won by traditionally Eurosceptic parties. So some downside risk to bonds would be removed. But this doesn’t necessarily mean that bond yields would be much lower under Mr Draghi than any other prime minister, because the main driver of yields and spreads is now the ECB. Whether or not he succeeds in forming a government, we expect the Bank to drive yields and spreads down this year in order to loosen financial conditions and give the economy a boost.
Jack Allen-Reynolds, Senior Europe Economist, email@example.com