Opinion | Britain has replaced Italy as Europe’s problem economy

Earlier this month, naysayers anticipating the next financial crisis in Europe pointed to Italy. As predicted by the pessimists, Italians have elected a populist coalition led by the post-fascist party, Brothers of Italy. But a funny reversal has occurred. Italy’s economy seems stable for the time being. Great Britain has become the weak power in Europe.

What gives? The intellectual fad has been running against globalization for a number of years, so it’s easy to overlook the answer. But the Italy-Britain inversion underscores an old lesson. Sacrificing a piece of sovereignty and submitting to the rules of international organizations is not necessarily a bad thing. If the rules work reasonably well, this can be an advantage.

Although the responsible government led by economist Mario Draghi has been sacked and replaced by an unsavory populist coalition, thanks to the European Union, Italy is in sane shape. As loud as the populists used to denounce Germanic orthodoxy in Europe, they are now promising to implement the economic plan drafted by Draghi and approved by the EU – not least because it comes with almost $200 billion in post-pandemic reconstruction aid from Brussels.

Italy’s populists also want the European Central Bank in their corner. Fearing another eurozone crisis triggered by price shocks from the Ukraine war, the central bank launched a bond-buying program over the summer to protect struggling countries from hedge-fund shorting. To keep access to this support, Italy must avoid crazy politics.

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In short, this is not the Europe of a dozen years ago. Rather than belatedly and reluctantly responding to signs of stress, the continent is trying to forestall problems. Italy has deep structural weaknesses ranging from demographics to debt, and a lot could still go wrong. But now the smart money relies on its stability.

Meanwhile, Britain, having left the EU and never been a member of the eurozone, is in the opposite position. The new conservative government under Prime Minister Liz Truss sees almost no restrictions. She was expected to be brave. She turns out to be crazy.

The first sign came with their reaction to rising natural gas prices. To protect low-income Brits from choosing between heating and eating, Truss had to deliver subsidies. But she opted for an outrageously expensive cure and trampled on her party’s reputation for fiscal prudence. The Truss subsidies are set to last a full two years. They are particularly generous to the rich. According to the UK government’s own estimates, they will cost more than $60 billion over 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 uptrend.

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Megan McArdle: The era of giveaways is over. Britain’s tax cuts have to be paid for one way or another.

But that was just the rehearsal. On Friday, the Truss team announced a cutthroat package of unfunded tax cuts in a Reagan-like push for higher growth. This came despite the apparent risk that the stimulus would increase inflation, which is at 9.9 percent and is expected to rise. This is despite the impact on the UK public debt, which is expected to reach 90 per cent of gross domestic product in 2024-2025, up from 75 per cent before the pandemic. And it did so without allowing the government’s Office of Budget Responsibility to model the impact of its giveaways.

Not surprisingly, financial markets panicked. Two-year Treasury interest rates hit 4 percent, up from 0.4 percent a year ago, increasing the government’s likely debt burden. The pound was down 3.4 percent against the dollar by Friday’s close, its steepest decline in two years. Finance Minister Kwasi Kwarteng signaled over the weekend that he might cut taxes even further. The pound immediately fell another 4.7 percent when Asian markets opened on Monday, briefly falling to its lowest level since the free-currency system began in 1971. The pound then rallied on hopes that the Bank of England would intervene to stabilize it. When the bank said it would not hold an emergency meeting, the currency retreated again.

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Why did the Bank of England disappoint traders? It has only a modest stash of foreign exchange reserves, so it can’t prop up the pound by jumping in to buy a ton of it. Her only option is an emergency rate hike, on top of the 0.5 percent she delivered last week. This would help the pound and dampen inflation slightly by dampening import prices. But higher interest rates would send the economy into the abyss and increase the cost of servicing debt. Given the Truss team’s ruthless inclination, it could turn against the central bank and undermine its independence.

When the Brexit referendum impacted Britain’s access to its key export market, economic punishment was inevitable. But this is the first time that being in the currency union seems more attractive than being outside. The European Central Bank is in a far stronger crisis-fighting position than the Bank of England.