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Market forces pressure European leaders to reverse course

Giorgia Meloni, Liz Truss and others find that capital markets can be more powerful than opposition parties

Giorgia Meloni
Italian Prime Minister Giorgia Meloni during a visit to the White House on July 27.JONATHAN ERNST (REUTERS)
Álvaro Sánchez

Politics is often referred to as the art of the possible, an invaluable lesson learned this week by Italian Prime Minister Giorgia Meloni after she imposed a surprise tax on banks. Just a day after the Italian government introduced a new tax on financial institutions, it had to scramble and reduce the country’s target revenue from this tax from an estimated €4.5 billion ($4.96 billion) to a maximum of €1.8 billion ($1.98 billion).

The retreat underscores the inherent limitations of governments in implementing fiscal measures, especially when markets sense government overreach. After learning about the new tax, Italian bank stocks dropped sharply, leading to a loss of €9 billion ($9.9 billion) in market capitalization. This downturn also affected others in the European financial sector, including Banco Santander in Spain, Deutsche Bank in Germany, and Société Générale in France.

The worldwide media widely reported significant capital outflows caused by the measure, prompting the Italian government to backtrack and revise the tax, which will now only be imposed on 0.1% of a bank’s assets. What caused such a strong market reaction? According to Arcano’s chief economist, Ignacio de la Torre, Meloni ventured into a particularly sensitive area. “Differentiating between measures targeting multiple sectors and those aimed specifically at banks is crucial. Banks play a vital role as the primary source of financing in medium-sized economies, especially for small and medium-sized enterprises. It’s essential to carefully analyze potential consequences before implementing untested measures. When the banking sector experiences a significant decline in stock market performance due to an announcement like this, it can hinder its access to capital. This, in turn, could lead to a contraction in credit availability, ultimately resulting in slower economic growth and a negative impact on employment. The Italian government belatedly realized this and decided to change their approach,” he said.

Former Italian Treasury Secretary Lorenzo Codogno shares the same opinion. “Banks are easy targets for populists and attacking them attracts political support. But neglecting the importance of establishing a stable fiscal and competitive framework to attract investment poses risks. It may result in permanent damage to Italy’s economic attractiveness and impact the availability of credit, particularly for small and medium-sized enterprises, which are the backbone of the Italian economy,” he said.

There have been numerous examples, both recent and distant, illustrating how markets can impact or even disrupt government plans. One noteworthy recent case involved an overly aggressive tax cut by British Prime Minister Liz Truss. The staggering €50 billion ($55 billion) reduction, the U.K.’s largest in the last 50 years, primarily benefited high-income individuals and eliminated the top 45% income tax rate for individuals earning over €170,000 ($187,000) per year.

The market response was fierce as doubts about the sustainability of British debt took center stage in the debate. Investors withdrew and financing costs increased, leading to a significant decline in the value of the pound sterling. There were even concerns about potential impacts on pensions. To stabilize the situation, the Bank of England initiated a bond-buying program, but it was too late for the prime minister. Truss resigned just 45 days after taking office, making her the shortest-serving head of government in U.K. history.

Liz Truss’s swift departure underscores the power of market forces, which can accomplish what political opposition alone cannot, at least without massive public protests. In this case, there was a consensus that rolling back substantial tax cuts was good for the British economy. However, entrusting unelected players to decide what’s good or bad for the economy raises questions.

A quick look at Spain

Pressure doesn’t always yield results. Similar to Meloni in Italy, the Spanish government also introduced a new bank tax in July. This led to significant stock market declines of nearly 5% and a loss of over €5 billion ($5.5 billion) in market capitalization in a single day. The Spanish government wants to collect €7 billion ($7.7 billion) in two years through this tax and another one imposed on energy companies. Even though this projected tax revenue exceeds the amount that caused Meloni to stumble, investors calmed down and Spanish banks are now trading higher than before the tax announcement. However, during the sovereign debt crisis in 2012, Spain faced similar challenges from the markets. The risk premium soared, interest payments of over 7% became unsustainable, and the Spanish government under Mariano Rajoy was forced to implement tax hikes and severe austerity measures affecting civil servants, the unemployed and dependents.

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