When investing in sovereign debt, there is a level of trust involved—faith a government will return an investor’s principal plus interest without fail. But Franklin Templeton Fixed Income doesn’t see this as blind faith; it must be backed by verifiable economic metrics. In this excerpt from the latest “FT Thinks,” our Head of European Fixed Income David Zahn outlines how governments have changed in Europe, and how new politicians with fresh agendas can bolster confidence, or rouse concerns.

Will the EU Fall Apart or Stay Together?

Once upon a time, bonds backed by a government’s full faith and credit pledge were generally considered less risky than corporate bonds. Times have changed. In today’s political climate, not all governments inspire us with the same confidence.

Consider Italy. Last year, Rome’s new government was keen to deliver its pledge of overturning pension reforms and offering a citizens’ income for the unemployed. Widely popular with voters, Italy’s proposed budget rattled bond markets and frustrated European Union (EU) leaders in Brussels. Headlines in Europe and the United States warned a new euro crisis was looming.1

The chief reason? Eurozone firewalls—built to prevent a rerun of the 2010–2012 eurozone debt crisis—depend on Italy adhering to strict fiscal rules. And that seems to be the last thing Italy’s populists want to do.

Italy’s showdown with Brussels revived nagging anxieties about the currency union’s stability. If only the eurozone adopted a “fiscal union” like the United States, then things wouldn’t be so bad, says the International Monetary Fund (IMF).2

Establishing a federal EU government with tax and spending authority, however, is a deeply polarizing idea in Europe. It also lays bare a stark rift between the EU’s northern and southern economies. As a global firm with fixed income teams across Europe and the United States, we think the EU and US comparison offers a valuable perspective—one that could reveal a pathway forward for Europe. That said, the US approach by no means offers an economic panacea. The same pension issues that sparked Italy’s skirmish with Brussels loom even larger in the United States.