The Second Domino

| About: Vanguard FTSE (VGK)

Soon after the Brexit vote was announced, I made this comment:

This time around the UK was probably hurt somewhat; British stocks are down around 4% as I write. But French and German stocks are down 7% to 8%. The markets in southern Europe are down 10% to 15%. Brexit's most powerful effect is to make the eurozone crisis worse, by increasing doubts as to whether the eurozone will stay together. By analogy, the 1931 UK decision to leave gold made things worse for the rest of the gold standard, indeed a surge of public and private gold hoarding over the next few months drove global commodity prices sharply lower.

While the pundits were talking about the UK, the markets immediately saw that the real risk was in southern Europe. Unfortunately, it looks like the markets and I were right. Now the second domino is teetering:

As Europe reels from the effects of the United Kingdom's Brexit vote, there's fresh anxiety about another referendum coming up in a major EU country.

It won't be a vote on whether to remain or to leave the European Union, but on Italy's constitutional reform package. Italian Prime Minister Matteo Renzi says the reforms -- which would simplify and accelerate the passage of laws -- are long overdue and will finally bring an end to decades of his country's notorious revolving-door governments.

But Italian analysts say the October vote could turn into a referendum on the Italian government itself -- and could prove as much of a boomerang for Renzi, who has been prime minister for 2 1/2 years, as the U.K. referendum has been for David Cameron.

Complicating matters further are Italy's banking problems. Italy's banks are burdened by $400 billion in bad loans, one-third the eurozone total. These problems predate the arrival of Renzi's center-left government, but they have become a politically explosive issue after thousands of small depositors were wiped out at four regional banks over the last year and several savers who lost all their money committed suicide.

Many analysts warn that with its shaky banking system, lackluster growth, high unemployment and a growing wave of anti-establishment public sentiment, Italy is on the brink of a major crisis. The trigger could be Renzi's constitutional reforms referendum.

The media are now full of reports that Italian banks are in trouble, and could push the entire eurozone into crisis:

Italy is on the cusp of tearing Europe apart but the economic and political crisis brewing in the nation is largely going unnoticed...

"If the referendum is rejected, we would expect the fall of Renzi's government. Forming a stable government majority either before or after a new election could become extremely challenging even by Italian standards," Deutsche Bank analysts led by Marco Stringa said in a note to clients in May. Fears that the reforms will be rejected have intensified since the eurosceptic vote won in Britain.

Here's what could happen if the referendum fails:

The destabilizing potential of such an outcome causes deep anxiety in European capitals, because the party likely to benefit most from early elections is the anti-establishment 5 Star Movement.

Founded seven years ago, it sprang from a satirical blog started by comedian Beppe Grillo. The party won 19 out of 20 cities -- including Turin and Rome -- in local elections held on June 20.

Analysts attributed the 5 Star Movement's success to a wave of popular anger with entrenched political elites and insecurity over economic stagnation and the growing presence of migrants. Unlike the overtly right-wing, xenophobic parties gaining ground in other parts of Europe, the 5 Star Movement won votes in these local elections across the political spectrum, appealing to voters on the right, center and left. . . .

Grillo has repeatedly criticized what he sees as excessive restrictions imposed on eurozone member states and has vowed to push for an Italian referendum on whether to remain in the eurozone. Should that ever come to pass and a "no" vote win -- returning Italy to the lira as its currency -- German economist Wolfgang Munchau, writing in the Financial Times, predicts a devastating outcome: "An Italian exit from the single currency would trigger the total collapse of the Eurozone within a very short period."

He also warns: "It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash."

Fortunately America remains a rock of political stability, not susceptible to the appeal of clownish buffoons with no governing experience who don't fit neatly into left and right categories, and who favor breaking up the EU.

Seriously, I view the ECB as the key to the crisis. I certainly don't think ECB policy should be aimed at rescuing Italian banks, but the eurozone desperately needs much faster NGDP growth, even if the Italian banking system were in fine shape. And faster NGDP growth would have the side effect of boosting the Italian economy. Easier money in the US would also help, but this is primarily an ECB problem, which they have to fix.

If everything unravels in Europe, with the EU collapsing and nationalistic parties taking over, there will be plenty of blame to go around. But the primary culprit will be the ECB, which has held the eurozone in a monetary straightjacket since 2008, with far too little NGDP growth for a healthy labor market, or a healthy financial system.

Let me try to head off some comments that might talk about individual countries. As far as the ECB is concerned, the health of individual countries (including Germany) is TOTALLY irrelevant. What matters is the eurozone as a whole, where monetary policy has been and is still far too tight.

PS. When I read this sentence:

The destabilizing potential of such an outcome causes deep anxiety in European capitals . . .

I immediately thought back to my research on the Great Depression, when I read dozens of similar news reports in the New York Times. Here's a brief excerpt from my book, discussing late 1929:

In late October it appeared unlikely that the German petition [to repeal the war debts agreement] would be successful, and thus it is unlikely to have been a significant contributor to the October crash. An October 29 New York Times headline prematurely called the "Anti-Young Plan Vote a Nationalist Rout," and then six days later had to backtrack with a report that the nationalists had surprised everyone by collecting the 4 million signatures necessary to force a referendum on the Young Plan. At the same time, the Briand government in France was replaced by a more hawkish regime headed by Tardieu. The weak opening on the German Boerse on Monday, November 4, was attributed to both the German referendum and to the gains made by reactionaries in France. And the U.S. market, which had been widely expected to open higher, instead plunged by 5.8 percent.

Guess who supported the agreement to tear up the German war debts?

Originally published on EconLog