Paolo Gentiloni: Macroeconomic Governance in the Crosshairs

Paolo Gentiloni began his tenure as European Commissioner today by giving an interview in Corriere della Sera. He spoke about a number of the major issues the new Commission has to face, but the part of the conversation that made the front page ran something like ‘the reform of the European Stability Mechanism is not a threat.’ Flip to page three and the title is even more explicit: ‘There is no plot in Brussels against Italy.’ European macroeconomic policy coordination is politically explosive. Gentiloni is the Commission’s first line of defence.

The new Italian Commissioner is well equipped to meet the challenge, both in Italy and elsewhere. To begin with, he understands fundamentally why the issues are so salient. On the surface, the reforms that are deeply dividing the Italian coalition seem relatively minor. The latest version of the treaty gives the European Stability Mechanism a role alongside the European Commission in supervising those countries that need a bailout in times of crisis. This is hardly the stuff of revolution.

The problem in Italy is that this new form of supervision smacks of a return to the ‘external constraint’ or vincolo esterno on Italian economic policymaking. Rejection of that kind of restraint was one of the big issues that the Five Star Movement had in common with the Lega during the last government. Pushing back against the external constraint was something that Gentiloni did as well, both in his role as prime minister and when he served as foreign minister in Matteo Renzi’s government. Gentiloni was more diplomatic and less confrontational than the coalition that succeeded him, but he was no less firm in asserting Italian interests in a way that provided reassurance at home.

The problem for Gentiloni is that the Italian government will have to make concessions somewhere. Right now, the Italian Prime Minister, Giuseppe Conte, is planning to tie the reform of the European Stability Mechanism to the completion of Europe’s banking union. That linkage is likely to make matters worse rather than better. Italy is under pressure to place limits on the exposure of domestic banks to Italian sovereign debt as part of the ‘risk reduction’ measures that many other governments in Europe – not least in Germany and the Netherlands – believe should run ahead of any ‘risk sharing’ through a some kind of backstop for national deposit insurance arrangements.

The reforms agreed for the European Stability Mechanism may be toxic for political and symbolic reasons, but this proposal to limit sovereign debt exposures has real practical significance for profitability of the Italian banking system, even if only during the transition period. A big package deal is more likely to strengthen Italian resistance than to create some opportunity for a trade-off: Lega leader Matteo Salvini has been quick to muddy the waters by announcing that Conte is threatening to sell out the country and wipe out the banks.

Moreover, Italy is only a single illustration of the challenges that Gentiloni will have to manage. Italians are not alone in being sensitive about the autonomy they have in setting fiscal policy and about the solvency of their financial institutions. Both issues are lodestones in Germany and France, although the specifics are different. French President Emmanuel Macron has to juggle pension reforms and Yellow Vests; German Chancellor Angela Merkel has to square demands for consistent budget surpluses and green investments. It is small wonder, therefore, that the European Union’s multi-annual financial framework remains a work in progress. Gentiloni will not have to manage those negotiations but he will need to think hard about how to create the conditions within which the budget talks can move forward.

Gentiloni will also have to think about how to address the constraints on the European Central Bank (ECB). When ECB President Mario Draghi left office, he made it clear that he believed the European Union needs some kind of fiscal instrument large enough to contribute to the management of macroeconomic performance in the euro area. Draghi made that argument in part because he had little success convincing national governments to use fiscal policy in the interests of Europe and in part because he recognized that monetary policy is already overextended. Draghi insisted, of course, that the ECB can always do more. What he had to concede, however, is that having the ECB do more would not necessarily be more effective. Indeed, he argued repeatedly that having a complementary fiscal policy was the key to increase the effectiveness of monetary policy.

Now Draghi’s successor, Christine Lagarde, faces an even more complicated dilemma. The ECB’s policy instruments are closer to the limits of their usefulness, the Governing Council is divided over how monetary policy should be understood and implemented, the prospects for some kind of European fiscal instrument are fading into the distance. The question is whether and to what extent Gentiloni and the rest of the European Commission can help alleviate some of the pressure. Gentiloni can do this by encouraging the member state governments to focus more clearly on the common interest they have in strengthening macroeconomic performance, by pushing hard for a completion of Europe’s banking union as the best means for restoring financial market integration and so strengthening the effectiveness of monetary policy, and by reassuring financial market participants that the institutions created after the last crisis are more than adequate to prevent the next one from occurring.

Unsurprisingly, this agenda brings Gentiloni back to Italy. For many governments in northern Europe, Italy is the test case for macroeconomic policy coordination. What they want to know is that the moral hazard that arises from common European institutions can be managed in the domestic political arena – and hence the attention to risk reduction and financial regulation. Gentiloni needs to find some way to help the Italian government provide that sense of reassurance without trampling on Italian political sensitivities. If he can pull that off, then he will not eliminate the other challenges he faces, but he will make them easier to address.

This piece was originally published on the Encompass Europe website. The picture is borrowed from that website as well. You can find the original version here.