At the start of this month, doom-mongers looking for the next financial crisis in Europe were pointing at Italy. Just as the pessimists predicted, Italians have elected a populist coalition led by the post-fascist Brothers of Italy party. But a funny reversal has occurred. Italy’s economy seems provisionally stable. Britain has emerged as the weak power in Europe.
What gives? Intellectual fashion has been running against globalization for several years, so it’s easy to miss the answer. But the Italy-Britain inversion underlines an old lesson. Sacrificing some sovereignty and submitting to the rules of international organizations are not necessarily bad things. If the rules work reasonably well, doing so can be an advantage.
Despite junking the responsible government led by economist Mario Draghi, and despite replacing him with an unsavory populist coalition, Italy is in reasonable shape because of the European Union. However loudly the populists used to denounce Europe’s Germanic orthodoxy, they now promise to implement the economic plan drawn up by Draghi and approved by the E.U. — not least because it comes with almost $200 billion of post-pandemic recovery aid from Brussels.
Italy’s populists also want the European Central Bank in their corner. Over the summer, fearing another euro-zone crisis triggered by the price shocks from the Ukraine war, the central bank created a bond-buying program to protect wobbly countries from short-selling hedge funds. To retain access to this support, Italy has to avoid crazy policies.
In short, this is not the Europe of a dozen years ago. Rather than reacting belatedly and grudgingly to signs of stress, the continent is trying to preempt problems. Italy has deep structural fragilities, ranging from demography to debt, and much could still go wrong. But for now the smart money is on its stability.
Meanwhile, having left the E.U., and having never been a member of the euro zone, Britain is in the opposite position. The new Conservative government led by Prime Minister Liz Truss faces almost no constraints. She was expected to be bold. She is turning out to be bonkers.
The first sign came with her response to soaring natural gas prices. To protect low-income Britons from a choice between heating and eating, Truss had to deliver subsidies. But she opted for a monstrously expensive remedy, trampling her party’s reputation for budgetary prudence. The Truss subsidies are due to last for fully two years. They are especially generous to the rich. By the U.K. government’s own estimates, they will cost more than $60 billion in the next six months, a whopping 4.7 percent of GDP over the period. Because of their design, they will end up costing even more if natural gas prices experience another upward hit.
But that was just the rehearsal. On Friday, in a Reaganesque bid for higher growth, the Truss team announced a ruinous package of unfunded tax cuts. It did this despite the obvious danger that the stimulus would add to inflation, which is at 9.9 percent and expected to rise. It did this despite the impact on Britain’s national debt, which is forecast to hit 90 percent of gross domestic product in 2024-2025, up from 75 percent before the pandemic. And it did this without allowing the government’s Office of Budget Responsibility to model the impact of its giveaways.
Not surprisingly, financial markets panicked. Interest rates on two-year government bonds hit 4 percent, up from 0.4 percent a year ago, adding to the government’s prospective debt burden. The pound fell 3.4 percent against the dollar by day-end Friday, its steepest drop in two years. Over the weekend, finance minister Kwasi Kwarteng signaled that he might cut taxes some more. The pound promptly fell a further 4.7 percent when Asian markets opened Monday, sinking briefly to its lowest level since the system of floating currencies began in 1971. The pound then rallied on the hope that the Bank of England would step in to stabilize it. When the bank said it would not hold an emergency meeting, the currency headed down again.
Why did the Bank of England disappoint the traders? It has only a modest stockpile of foreign currency reserves, so it cannot prop up the pound by stepping in to buy a ton of it. Its only option is an emergency interest rate hike, on top of the 0.5 percent it delivered last week. This would help the pound, and by dampening import prices it would mildly restrain inflation. But higher interest rates would drive the economy into a ditch and raise the cost of servicing the national debt. Given the Truss team’s reckless bent, it might lash out against the central bank and undermine its independence.
When the Brexit referendum damaged Britain’s access to its key export market, an economic penalty was inevitable. But this is the first time that being in the currency union has looked more attractive than being outside it. The European Central Bank is in a far stronger crisis-fighting position than the Bank of England.
Sebastian Mallaby is the Paul A. Volcker senior fellow for international economics at the Council on Foreign Relations and a contributing columnist for The Washington Post. He is the author, most recently, of "The Power Law: Venture Capital and the Making of the New Future”, published in February 2022.