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Sunday, August 17, 2014

The Italian Runaway Train

There has been lot's of debate in the press and in academic circles over the last week or so about whether Italy's latest contraction constitutes a triple dip recession or simply a continuation of what's been going on over many many years. This is an interesting theoretical nicety, but in fact what is happening in Italy at the moment goes a lot further than problems faced by a recession dating committee. The real issue that arises in the context of the Euro Area at the moment is a far more specific one. Will the ECB do QE? And if it does when will it push the button? And what could happen if it doesn't. Perhaps a case study of the Italian case is worth the effort here. What is likely to happen to Italian debt if there is no ECB intervention soon? Let's take a look at the dynamics.

By now almost everyone and their grandad knows that Italy is back in recession following the 0.2% GDP contraction in the second quarter.


Not only did this result suggest that Italy was now in a triple dip recession (or a twenty year decline), it also meant that GDP was back at the same level it had in 2000, when the country entered the Euro currency union.



The problem is that Italy has an appallingly low trend GDP growth rate - possibly negative at this point - and nothing which has happened since the financial crisis ended suggests it is going to to improve radically anytime soon, in fact there are good reasons to think that  growth could  even deteriorate further.


In the first place Italy's working age population is now falling, and many young educated Italians are leaving to work elsewhere







And now, not only do we have the legacy then of high debt and low growth, a new problem has emerged: low inflation or even deflation. Italy's inflation has fallen to zero.


The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP (or GDP at current rather than constant prices). If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even continue to contract (as has happened in Japan). The result is bound to be that the gross government debt to GDP ratio rises above the 135.6% it hit in March.


One of the arguments frequently advanced about how this dynamic could be turned around would be for Italy to run a "large" primary budget surplus. Now the emphasis here is on large since the country has in fact run a primary surplus (income - expenditure before paying debt interest) since the early 1990s, but that hasn't stopped the weight of the debt climbing and climbing.

The IMF, in their 2013 Fiscal Monitor outlined  a scenario in which the obligations of heavily indebted European sovereigns first stabilise, and then fall to the 60% level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables, and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. As they point out, the heavier the debt, the higher the interest rate and the slower the growth rate, the larger the requisite surplus. In fact they found that the average primary surplus required in the decade 2020-2030 was 5.6% for Ireland, 6.6% for Italy, 5.9% for Portugal, 4.0% for Spain, and 7.2% for Greece.

Is it plausible that Italy could run an average primary surplus of 6.6% of GDP over a decade? Hardly - in particular this implies that on average, every year, the government would be draining out 6.6% of GDP from domestic demand via taxation. Yet as I have noted many times, domestic demand is precisely the weak point in the Italian economy (secular stagnation, ageing population).



As Eichengreen and Panizzi (who studied the plausibility of the IMF projections) conclude:
"These are large primary surpluses. There are both political and economic reasons for questioning whether they are plausible.............History suggests that such behaviour, while not entirely unknown, is exceptional....... On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected."
Italy's situation is to some extent replicated in other countries on the periphery (Ireland sovereign debt to GDP 124%, Portugal 132.9%, Spain 96.8% and Greece 174.1%, all numbers as of March 2014) since almost all official forecasts anticipate an imminent turnaround in the debt dynamic. If secular stagnation and ultra low inflation really set in this turnaround is going to be impossible to achieve and Europe's leaders will need to decide what to do about it.

Italy's debt now looks certain to climb towards 140% of GDP and beyond (maybe hitting that level as early as Q1 2015), meaning someone somewhere in the official sector should be able to recognize that it is not on a sustainable path. The so called AQRs (bank Assett Quality Reviews) are probably not going to generate too many surprises, but what about doing some realistic DSA's (Debt Sustainability Analyses)?

Cases like Greece and Portugal are to some extent containable from an EU perspective since the economies are small enough for EU leaders to engage in some sort of extend and pretend via low coupons and long horizon maturities. But Italy's debt is simply too big to be manageable in this way.

So EU leaders and the ECB now face a dilemma. Trying to make Italy comply with its EU deficit and debt obligations may well mean that the deficit comes down but in all probability the debt level will go up (given the weak nominal GDP effect). Not complying with them opens the possibility of stimulating slightly more growth (and possibly mildly stronger inflation) but naturally the debt level will rise. It's a sort of damned if I do and damned if I don't situation, since either way the debt burden rises.

From the point of view of the country's political leaders though, it is obvious that austerity today has costs (and few visible benefits) while deficit spending may bring some short term benefit at the price of hypothetical longer term debt issues. It shouldn't surprise us then if they go for the latter, especially since Japan's political leaders have been widely applauded for doing something similar.

Naturally, since the difficulties the onset of secular stagnation will produce for heavily indebted countries with ageing and shrinking workforces are not widely understood, hints that deficit objective relaxation calls are growing have not been well received everywhere. During the spring the FT published details of a document jointly issued by the German and Finnish finance ministries which strongly rebuked Brussels for easing austerity demands, citing in particular the additional flexibility given to France and Spain for reducing their budgets to within EU deficit limits.

“Since 2012, the commission has substantially changed the way it assesses whether a member state has taken ‘effective action’ to comply with [EU budget rules],” the memo states. “The recent methodological changes imply the risk of watering down the newly strengthened [rules] at its implementation stage.”

As might have been expected, Matteo Renzi was not slow in coming forward to seek similar treatment for his country (See "Italy request to push back budget targets dismays Brussels" FT April 17). According to the newspaper the country's finance minister, Pier Carlo Padoan, sent a formal written request to the commission on 16 April seeking authorisation for a change in objectives. Citing the “severe recession” that set Italy back in 2012 and 2013, Mr Padoan wrote that Italy wanted to “deviate temporarily from the budget targets” and that because of “exceptional circumstances” (my emphasis throughout) the government had decided to accelerate the payment of arrears owed by the public to the private sector by €13bn, which would increase the debt to GDP ratio in 2014. The trouble is that these "temporary factors" and "exceptional conditions" seem to arise with a predictable regularity in Italy's case. The country is currently aiming for a balanced structural budget in 2016 rather than 2015 as agreed with Mario Monti’s technocrat government in 2012. A year earlier, then prime minister Silvio Berlusconi had promised a balanced structural budget by 2013.


Enter Mario Draghi

The relationship between Mario Draghi and Matteo Renzi has long been a source of speculation and gossip. Shortly after he came to office in February following a kind of palace revolution inside his own party whereby the incumbent Prime Minister - Enrico Letta - was unceremoniously defenestrated the Financial Times Brussels correspondent even published a post on an FT blog with the rather direct title: Does Renzi owe his job to Draghi? 

The gist of the article was an attempt to establish some sort of  connection between Matteo Renzi's arrival in office and the the outcome of the then recent German Constitutional Court ruling which put into question the viability of the central bank's OMT (Outright Monetary Transactions)  programme. Spiegel's hypothesis was that the driving force for some kind of  "unholy alliance" between the two of them lay in Draghi's interest in getting prime minister Letta out of  office before pressure from within Germany about maintaining open the offer of a now legally questionable  OMT programme to an Italy which was visibly enjoying cheaper bond yields - but was manifestly not advancing with its reform programme -  became too strong to withstand.
    "Do last week’s German constitutional court ruling lambasting – but failing to overturn – the ECB’s crisis-fighting bond-buying programme and Matteo Renzi’s ousting of Italy’s prime minister Enrico Letta have anything in common? In the view of many ECB critics, particularly in Berlin, the two are not only related, but one may have caused the other."

"In the view of many German critics, there has been no serious effort by the Italian government – be it in the fading months of Mario Monti’s premiership or during Enrico Letta’s foreshortened tenure – to undertake major economic reforms since ECB boss Mario Draghi first announced he would do “whatever it takes” to save the euro in July 2012."

The key part of the background here  is that the German court ruling effectively left OMT - which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side - deader than that infamous dead duck. Karlsruhe's objection to the existing bond buying programme was that it went beyond the ECB's mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk - which could have offered an alternative justification for OMT - is for the moment off the table, OMT lacked definitive legal justification and in practical terms the emperor visibly had no clothes. It was just a question of how long the markets needed to wake up to the fact.

So it was imperative to find some other justification for the initiation of a bond purchases programme should one be needed. Then along came deflation. The important point is that if a programme of bond purchases is implemented as a form of QE it will differ from the earlier OMT programme in terms of the justification offered. Any QE programme introduced to combat deflation would be implemented as part of an attempt to attain price stability, an objective which does lie within the central bank mandate. Another key difference is that if QE is launched and involves bond purchases the bank will buy bonds from ALL countries in the monetary union (according to their weight in Euro Area GDP), which brings us to the third difference from OMT: there will be no conditionality attached. Given this it became a "high risk" operation and  it was clear that Mario Draghi needed someone else at Italy's helm if he wanted to be able get the Germans on board with QE, someone who could convince them Italy would enact the required reforms. Enter Matteo Renzi.

Now fast forward to August, and we find the former mayor of Florence who had surged to office on the back of promises to enact aggressive labour market reforms, a battery of spending and tax cuts and significant privatizations has been strong on talking and very weak on action. Something which is not uncommon in Italy, but people had expected more. They thought this time was different.

Mario Draghi's irritation with the situation was visible at the August ECB press conference. When asked by one of the journalists why Italy had fallen back into recession he could hardly contain himself, and was unusually direct in saying a lack of structural reforms was holding the country back and hampering a return to growth. The reference to Renzi was evident.

One week later the two met, in what they had obviously hoped would be a secret meeting but Italy being Italy the press went along for the ride. While no details of what happened at this meeting have transpired it is pretty clear Draghi will have used the opportunity to read his fellow countryman the riot act. Italy has been full of talk about some kind of Troika intervention, but this is most unlikely, and Renzi made it pretty clear in his Financial Times interview that he personally wouldn't be asking for one.

When asked why Italy's reform pace seemed so slow he rejected Draghi's suggestion that the EU should intervene in countries where reforms were not being implemented fast enough. “I agree with Draghi when he says that Italy needs to make reforms but how we are going to do them I will decide, not the Troika, not the ECB, not the European Commission,” he said. “I will do the reforms myself because Italy does not need someone else to explain what to do."

The problem is that with the debt dynamics we have seen above the one thing Italy doesn't have at this point is time. It isn't a problem of the impact of a so called "debt snowball" as interest rate payments send debt levels spiraling upwards. If anything it's worse. Mario Draghi can, in theory, contain the debt interest problem, and if needs be along with it the capital repayments schedule. But the problem Italy has at the moment is one of the credibility of its debt, of the country being able to convincingly argue its trajectory is sustainable, of being able to convince the Germans that if the ECB were to buy bonds these they could EVER be redeemed.

While Renzi has waxed eloquently about transforming Italy, buoyed on by the results of the European Parliament elections he seems more concerned with pushing through electoral reform - which is obviously needed but is not perhaps as pressing as the growth and debt problem - leaving the suspicion that he is more interested in getting re-elected than anything else. Indeed the fact that he needs the support of the discredited former Prime Minister Silvio Berlusconi to get the reform through with any kind of urgency (see Italy Slips Back Into Recession, As New PM seeks Berlusconi's Help)  has lead critics of the two "institutional parties" to suggest the reform may be more about getting rid of newcomers like Beppe Grillo's Five Star movement than anything else (see Renzi slammed for "coup" over senate changes) .

To date Renzi's government - which is almost operating outside real historical time in terms of economic issues -  has made little progress on the sort of  reforms which might help the country recover some kind of growth, like those to the judicial system and the labor market. The only measure that could be considered vaguely "pro-growth" that his government has enacted was the 80 euro bonus delivered to low-wage workers hasn't boosted the economy as its proponents claimed. The measure seems more cosmetic - comparable with José Luis Zapatero's ridiculous "Plan E" in Spain - and only reinforces the impression of politicians fiddling while Rome burns. The business lobby Confcommercio, which was highly critical of the measure, calculated that consumption was boosted by just 0.1% in June, the first month in which the tax relief was operative. In their press release they said Italian families were holding back from shopping “because their uncertainty about the future was stronger than the actual increase in funds in their pockets”.

Despite this Prime Minister Renzi continues to insist that his government's economic strategy is sound and will lift the country out of crisis.In a lengthy interview broadcast on La7 television following the announcement of the GDP results, Renzi said that his government was determined to get the economy back on track, but in due course. "We will work better and harder, but I promised to change direction, not to change the universe in three months time," Renzi said, adding that only a "comic book superhero" could turn around the economy in a matter of months. "Calmly, serenely, we are taking this country by the hand and pulling it out of the crisis," Renzi told listeners.

The problem outside observers are having is not in seeing the complete turnaround - Renzi is right here, this involves a long painful road - but in identifying the first baby steps that are being taken.

And fears about Mr Renzi’s grasp on Italy’s finances were fanned again last week when spending review commissioner Carlo Cottarelli highlighted the tensions which existed in the government over the prime minister’s spending plans. In a post on his blog, Mr Cottarelli - who was appointed by Letta and was previously Director of the Fiscal Affairs Department at the IMF - said that earlier savings were already being used by parliament for other expenditure, meaning that in the longer term they could not be used to reduce taxes on employment (which is what they were intended for).

Renzi normally responds to critics that all points of view are valid but 11 million Italians think differently, in a clear reference to what he perceives to be his electoral support. But even this will eventually wane if progress is not seen to be made on the economy. The FT quotes Wolfango Piccoli, analyst at Rome-based think-tank Teneo, to the following effect: “As prime minister Matteo Renzi struggles to make progress on political reform, it is becoming increasingly clear that his government lacks an original and coherent plan for the economy,” 

To add insult to injury, more bureaucratic delays mean that the treasury will not hit its target to raise €12bn from privatizations this year. There are also concerns about the outcome of the European Central Bank’s stress tests and asset quality review of the country’s leading banks. Bankers point out that if an Italian bank needs a bail out the state’s coffers will not easily be able to support it. Of course here we have a mighty instrument which Draghi can use to twist Renzi's arm.

Another issue is labour market reform. The controversial Article 18 of Italy's workers statute is "just a symbol", and "debating it is a pointless exercise", Renzi told State broadcaster RAI 3 last week. The comments came after Interior Minister Angelino Alfano, who comes from the New Center Right (NCD) party, called for its abolition. Article 18 of the 1970 Workers Statue is a law that forbids companies with over 15 employees from firing people without just cause.

The Italian Prime Ministers reluctance to tackle the labour market issue is understandable. Any attempt to really change Italian labour law would be deeply unpopular on the left (and even among many in his own party) and a direct clash with Italy's unions would surely cost him votes if his plan is to hold elections after passing a new electoral law. More fiddling while Rome Burns.

So Which Way For The ECB?

Evidently members of the EU Commission, ECB governing council members, and senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. The secular stagnation hypothesis is at this point more akin to a theoretical research strategy than a workable template for policy-making, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. As the editors of a recent book on the topic put it in their introduction: "Secular stagnation proved illusory after the Great Depression. It may well prove to be so after the Great Recession – it is still too early to tell. Uncertainty, however, is no excuse for inactivity. Most actions are no-regret policies anyway". As they suggest the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (see here) and if it doesn't what happens to all the accumulated debt?



On the other hand time always has a cost. Letting things drift further means letting debt levels rise, and risking testing market patience and this becomes especially important in the cases of Italy and Portugal. The longer time passes the more difficult it is going to be for anyone to convince themselves that the debt of these countries is sustainable.

So there may come a point after which the Germans simply will not allow Draghi to buy Italian bonds without a prior haircut. OK, they've said they won't do more PSI, but they've said a lot of things, and the cost of irritating investors is limited when you have a regional current account surplus and a central bank buying bonds.

Maybe the costs of the Euro "widowmaker" trade will be borne by all those eager bond purchasers who thought nothing could possibly go wrong. I am sure German politicians would decide a loss of credibility on PSI would be less costly to them than getting German taxpayers on the hook for current Italian debt levels. Especially in a country where they are now proudly announcing they have reduced government debt for the first time in more than 50 years. So in this case, maybe the turkeys just did vote for Xmas.

The thing is, despite the meeting between Draghi and Renzi (who may also be a turkey by Xmas) nothing substantial is going to happen in Italy. The government is under no pressure to ask for help (and doesn't even feel it needs it), and Draghi won't act before things change. Gridlock - with rising debt.

Naturally in the short term the “Mario Draghi ultimately has my back” feeling will still prevail, but with markets continuing to finance debt levels that any official study will soon have to recognize as unsustainable lack of proactive policies from the ECB will only fuel concerns that the size of the pill may become just too big for the bank to persuade Germany comfortably swallow, leaving the specter of private sector involvement to once more rear its ugly head. How do you tell people who have just sacrificed hard to get their debt under control that they are now about to help "pardon" 50% of someone else's. It simply doesn't make sense.

Sunday, May 18, 2014

On The Trail Of Italian Debt

Looking for trends and correlations in that landslide of economic data which arrives, day in and day out, on our desks is normally something akin to trying to find a needle in a very large and raggedy haystack. From time to time, however, some things are just to obvious not to be noticed, like the ever rising levels of debt on the EU periphery and the growing demand from political leaders there for some kind of QE type initiative from the European central bank, for example. Sure, there is no obvious causal connecting here - the missing "middle term" linking the two would probably be all that ongoing deflation risk - but the inability of governments to contain their debt levels is a consequence of having low growth and low inflation, as is the wish being ever more insistently expressed by Southern Europe's political leaders that the ECB were more like the Bank of Japan.

In this context the latest batch of Euro Area GDP numbers must have come like a bucket of ice cold water thrown across the luke warm recovery hopes of policymakers in Frankfurt, Brussels and Berlin. Only the German economy put in a really impressive performance (0.8% quarter on quarter). Spain's economy also did well, but the 0.4% quarterly growth failed to convince due to the fact that the main influences on the number were a 1.2% fall in imports and a 0.4% negative inflation calculation (see my analysis here).



France's economy stagnated, but more worryingly for policymakers core Europe countries like Finland (minus 0.4 q-o-q)  and the Netherlands (minus 1.4%) failed to shake off their long running recessionary drag, while periphery growth laggards like Portugal (minus 0.7%) and Italy (minus 0.1%) fell back again into negative growth territory. Clearly the Euro Area seems to be stuck in some form of secular stagnation, a feeling which is only confirmed by the very low inflation levels we are seeing and reinforced by the fact that both Portugal and Italy have suffered from chronically low growth rates since the start of the century.




Nothing which has happened since the crisis suggests this low trend growth rate is going to to improve radically, in fact there are good reasons to think that trend growth might even deteriorate further: both countries have higher debt loads (public and private combined) than when they entered the crisis, and in both cases working age populations have now started to decline. (See an excellent review of the Portugal situation by Valter Martins here and here).

Not only do we have a legacy then of high debt and low growth, a new problem has emerged: low inflation or even deflation. Italy's inflation has fallen to very low levels, while Portugal now has experienced 3 consecutive  months of negative annual inflation.





The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP (or GDP at current rather than constant prices). If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even contract (as has happened in Japan). This phenomenon has already started to make itself felt in Spain, as the following chart from the Spanish statistics office makes plain.


 We don't have any detailed data for Spain's Q1 2014 performance yet beyond the Bank of Spain initial estimates, but if this estimate is confirmed by the National Statistics Office then it is unlikely than nominal GDP at the end of March was much above the level it was at last June, despite the recovery in economic activity.  Which is one of the reasons that Spain's debt to GDP level has been rising so rapidly in the last 12 months. Naturally something similar has been happening to Italian debt, which rose from 127% of GDP in December 2012 to 132.6% GDP in December 2013, despite the fact the country only had an annual fiscal deficit of only 3% of GDP. Italy's nominal GDP fell in both 2012 and 2013, largely due to the sharp drop in economic activity. Nominal GDP may continue to fall in 2014, but this time because the GDP deflator is negative. If this happens the debt level will continue to rise confounding hopes for a turnaround in the dynamic.


Italy's situation is to some extent replicated in other countries on the periphery (Ireland sovereign debt to GDP 124%, Portugal 129%, Spain 93.9% and Greece 175%) since almost all official forecasts anticipate an imminent turnaround in the debt dynamic. If secular stagnation and ultra low inflation really set in this turnaround is going to be impossible to achieve and Europe's leaders will need to decide what to do about it. 

Italy is a good case in point here, since if debt were to climb towards 140% of GDP and beyond, then someone somewhere would surely have to officially recognize that it was not on a sustainable path. Cases like Greece and Portugal are to some extent manageable from an EU perspective since the economies are small enough for EU leaders to engage in some sort of extend and pretend via low coupons and long horizon maturities. But Italy's debt is simply too big to be manageable in this way.

So Italy's government faces a dilemma. Complying with its EU deficit and debt obligations may well mean that the deficit comes down but in all probability the debt level will go up (given the weak nominal GDP effect). Not complying with them opens the possibility to slightly more growth (and possibly stronger inflation) but naturally the debt level will rise. It's a sort of damned if I do and damned if I don't situation, since either way the debt burden rises.

From the point of view of the country's political leaders though, it is obvious that austerity today has costs (and few visible benefits) while deficit spending may bring some short term benefit at the price of hypothetical longer term debt issues. It shouldn't surprise us then if they go for the latter, especially since Japan's political leaders have been widely applauded for doing something similar.

Naturally, since the difficulties the onset of secular stagnation will produce for heavily indebted countries with ageing and shrinking workforces are not widely understood, hints that deficit objective relaxation calls are growing have not been well received everywhere.  The FT published details recently of a document jointly issued by the German and Finnish finance ministries which strongly rebuked Brussels for easing austerity demands, citing in particular the additional  flexibility given to France and Spain for reducing their budgets to within EU deficit limits. Although given the latest performance results for the Dutch and especially the Finnish economy ("Once Europe's lead preacher of budget prudence, Finland loses righteousness"), Germany may find itself increasingly out on a limb if it maintains this posture.
“Since 2012, the commission has substantially changed the way it assesses whether a member state has taken ‘effective action’ to comply with [EU budget rules],” the memo states. “The recent methodological changes imply the risk of watering down the newly strengthened [rules] at its implementation stage.”
As might have been expected, Matteo Renzi  has not been slow in coming forward to seek similar treatment for his country (See "Italy request to push back budget targets dismays Brussels" FT April 17). According to the newspaper the country's finance minister, Pier Carlo Padoan, sent a formal written request to the commission on 16 April seeking authorisation for a change in objectives. Citing the “severe recession” that set Italy back in 2012 and 2013, Mr Padoan wrote that Italy wanted to “deviate temporarily from the budget targets” and that because of “exceptional circumstances” (my emphasis throughout) the government had decided to accelerate the payment of arrears owed by the public to the private sector by €13bn, which would increase the debt to GDP ratio in 2014. The trouble is that these "temporary factors" and "exceptional conditions" seem to arise with a predictable regularity in Italy's case. The country is currently aiming for a balanced structural budget in 2016 rather than 2015 as agreed with Mario Monti’s technocrat government in 2012. A year earlier, then prime minister Silvio Berlusconi had promised a balanced structural budget by 2013.

Naturally Brussels was not amused (“Brussels is very upset,” one senior Italian official told the FT) and issued a statement to the effect that Italy's economic woes continued to require strict monitoring and "strong policy action".Such findings form part of the EU's new system of economic policy coordination and are aimed at preventing a repeat of the euro zone's debt crisis. The system requires governments to undergo repeated scrutiny of their economic performance to determine if there are economic trends and policies that are sowing the seeds of future problems.

But as Mathew Dalton pointed out in an article in the WSJ (Italy's Plea for Leeway Puts Brussels in a Bind) the problem facing Berlin and the EU Commission is far from straightforward.
The problem of Italy's debt is shaping up to be a key test of the European Union's complicated new system for controlling the finances of its member states. 
 The new budget rules are proving to be a source of conflict, pitting harder-line countries such as Germany and the Netherlands against broad swaths of Southern Europe that want more leeway on their budgets. Standing in the middle is the European Commission, the EU's executive arm, which has gained stronger authority to enforce the new rules.

Now it faces a crucial decision: Does it insist on a tough enforcement of the rules that could potentially plunge the Italian economy back into recession? Or does it give Rome some flexibility and risk undermining the new system that Brussels fought hard to establish to prevent a repeat of the region's debt crisis?
As Dalton points out the Commission will be wary of enforcing any rule which may undermine Matteo Renzi's credibility, aware as they will be that most of the alternatives are likely to be (from their point of view) far worse. Further, aside from the likely strong performance of Beppe Grillo in the forthcoming EU parliament elections the country is becoming increasingly eurosceptic (Italy turns from one of the most pro-EU countries, to the most eurosceptic ).

Secular Stagnation or No Secular Stagnation, That Is The Question


Evidently members of the EU Commission, ECB governing council members, or senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. Secular stagnation is at this point more akin to a theoretical research strategy than a template for policymaking, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. But the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (or here, or here) and if it doesn't what happens to all the accumulated debt?

Basically we are at the point where no easy answers are available, and where the best step we could take would be to try to start asking some of the right questions. Will, for example, unconventional Keynesian policy work as advertised in the case of declining-working-age-population induced secular stagnation? Paul Krugman seems to assume it can, when he asks himself whether there are "structural changes in Europe that arguably will lead to persistently lower demand unless offset by policy?" Exactly which policy/policies are we talking about here?

Larry Summers appears to take a similar view (Why stagnation might prove to be the new normal). But both economists are far from being unambiguous about the situation. Summers concludes his piece by saying that "the risk of financial instability" (being provoked by sustained non-conventional measures like Abenomics) "provides yet another reason why preempting structural stagnation is so profoundly important".

Europe, unfortunately has now been left to drift well  beyond that early "preemptive" stage. Paul Krugman concludes his review (Stagnation Without End, Amen) of what has to be the most substantial examination to date of the theoretical issues involved (Gauti Eggertsson and Neil Mehrotra's "A Model of Secular Stagnation") by asking himself "whether there is a possibility of sustaining the economy with permanent fiscal expansion". Naturally, the answer is important since if there isn't the validity of the whole Keynesian model which PK himself has been working with would be called into question. A point which is entirely lost on those who reject the secular stagnation hypothesis outright (I won't let mere facts get in my way) for inbuilt ideological reasons. As I say, finding a way forward to manage this problem is very much a matter of which questions you allow yourself to ask.

Thursday, February 27, 2014

Could Mario Draghi Implementing QE At The ECB Possibly Help Matteo Renzi Raise the Italian Deficit?

What a convoluted title! Still, the lack of formal elegance might just be compensated for by its communicative efficacy. The aim of the above header is to link two names in people's minds, both of them Italian: Mario Draghi and Matteo Renzi. Naturally the idea is not original, the FT's Peter Spiegel  recently published an entire blog post ( Does Renzi owe his job to Draghi?) trying to establish some sort of  connection between the arrival in office of Italy's Matteo Renzi and the recent German Constitutional Court ruling - in the process casting the central bank President in the role of midwife. Indeed, according to the FT,  Italy itself is currently rife with rumours about what might actually lie behind Renzi's meteoric rise, and  again the role alloted to Mr Draghi seems to be  rather more than an incidental one.

But this post is not about rumour, nor is it about speculation - beyond, that is, speculation about what the ECB might do in its campaign to keep the Eurozone deflation menace at bay. Rather than conspiracies (real or imagined) it is about coincidences and the role they so often play in shaping events and outcomes. In this sense the fact that Mario Renzi took over the helm of government in Italy just a short time after the German Constitutional Court ruled on the ECB's Outright Monetary Transactions (OMT) programme has real potential.

What we could call Spiegel's hypothesis suggests the driving force for the "unholy alliance" which may or may not have been forged between Matteo Renzi and Mario Draghi would be found in the latter's interest in getting prime minister Letta out of  office before pressure from within Germany about maintaining open the offer of a legally questionable  OMT programme to an Italy which was enjoying cheaper bond yields but was manifestly not advancing with its reform programme became too strong to withstand.

"Do last week’s German constitutional court ruling lambasting – but failing to overturn – the ECB’s crisis-fighting bond-buying programme and Matteo Renzi’s ousting of Italy’s prime minister Enrico Letta have anything in common? In the view of many ECB critics, particularly in Berlin, the two are not only related, but one may have caused the other."

"The German government has always had a bit of a love/hate relationship with the bond market throughout the four-year-old eurozone crisis. On the one hand, it regarded sovereign bond holders as greedy opportunists looking for German taxpayers to bail out their bad bets. On the other hand, those same traders were a useful tool to keep pressure on wayward governments – particularly Italy – that were in dire need of economic reforms to spur growth."

"In the view of many German critics, there has been no serious effort by the Italian government – be it in the fading months of Mario Monti’s premiership or during Enrico Letta’s foreshortened tenure – to undertake major economic reforms since ECB boss Mario Draghi first announced he would do “whatever it takes” to save the euro in July 2012."

"The bond-buying progamme that the German constitutional court grumbled about last week – known as Outright Monetary Transactions – was the product of that speech 18 months ago and has kept the crisis at bay ever since, helping keep Italian borrowing costs near pre-crisis levels."

Leaving aside the problem of mechanism - how could Mr Draghi or anyone else have stirred up participants in the Italian Democratic Party's primary election - the potential synergy between the two developments (the Karlsruhe ruling and the new government in Italy) is more than evident.

The key part of the background here, as Wolfgang Munchau has already pointed out, is that the German court ruling effectively left OMT - which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side - deader than that infamous dead duck. Karlsruhe's objection to the existing bond buying programme was that it went beyond the ECBs mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk - which could have offered an alternative justification for OMT - is for the moment off the table, OMT lacks definitive legal justification and in practical terms the emperor visibly has no clothes. It is just a question of how long the markets need to wake up to the fact.


Under these circumstances, as one argument would have it, it is only a matter of time before market sentiment turns and peripheral spreads come back under pressure at which point OMT would be tried tested and severely found wanting. While I think this risk to peripheral spreads in the short run is probably overstated (since at this point market participants are so bullish they are effectively immune to flashing red light warning signals), letting Italy simply drift does involve a high level of potential risk, and certainly a higher level of risk than a prudent central banker might want to run. So that part of it I buy: Mario Draghi would be at least rooting for Renzi even if he wasn't doing anything to actively make his wish come true.


But then, enter the deflation threat. The ECB is - and not without justification (see the above chart showing the movement in 5 year index linked forwards prepared by Commerzbank's Michael Schubert) - concerned about the possibility that longer term inflation expectations could become anchored well below the 2% price stability level the maintenance of which the ECB does consider to be its mandate. Aggregated inflation across the 18 countries who constitute the monetary union has fallen and remained below 1% for an extended period of time now. In several EU countries prices have actually started falling, in others inflation has dropped to very low levels of 0.5% or below. Greek inflation is currently running at an annual rate of minus 1.4% and has been in negative territory for eleven months now (see chart above). Worse still, and again as Wolfgang Munchau points out, there is a real risk that the periphery economies drag the German inflation rate down along with them.
"Germany’s federal statistics office said last week that real wages – after inflation – fell in 2013. This was unexpected because other surveys suggested they had gone up. What seems to have happened is profit-related pay and other hard-to-measure components of wages came down last year. For the eurozone, German deflation is a nightmare. If the periphery wants to become more competitive, it needs lower inflation than Germany. But if Germany, too, is deflating, then either the competitive adjustment will not happen; or the whole of the eurozone goes into deflation; or, more likely, both."

"Insee, the French statistics office, announced that the annual rate of core inflation – without volatile items and tax measures – dropped sharply from 0.6 per cent in December to 0.1 per cent in January. Factory prices are another forward-looking indicator. According to data from Eurostat, the EU’s statistical office, they went down in the eurozone as a whole by a whopping 0.8 per cent annually in December." 
 As he says, deflation in Germany would become a true "worst case scenario" nightmare for Euro Area monetary policy. So, with the risk continuing to rise the bank will need to do something, and  some version of Japan-style bond purchases seems to be the most likely thing it will do. Lowering interest rates or more initiating more LTROs simply wouldn't have a big enough impact (which doesn't mean that both of these might not happen taken as part of a broader package. This time the  FT's David Oakley explains:

"At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone.................. Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French Oats, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets......"

"The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012. Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets. The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within its remit as it is designed to bring about price stability....."
So the initiation of some kind of bond purchases programme at the ECB is looking increasingly likely. If such a programme is implemented it will differ from OMT in the justification offered (to try to attain the bank's inflation objective), the fact that the bank will buy bonds from ALL countries according to their weight in Euro Area GDP, and by the fact that there will be no conditionality attached. Naturally, the fact that they will initiate such a programme doesn't necessarily mean it will work and achieve its objective. As we can see in Japan, the effectiveness of the policy is questionable, but then a central bank can hardly say, "deflation ahoy, but there's nothing we can do about it".

Whether or not it is possible to reflate economies which have entered some kind of enduring process of secular stagnation - as Larry Summers obviously thinks you can (or see here) -  remains an open question as far as I'm concerned. If part of the problem is demographic - as I explain here and here in the context of Abenomics - then it is hard to see how you can. Possible we need to start to learn to live with deflation and find ways of managing the impact on the financial sector. As the FT's David Pilling so cogently put it recently in the Japanese context: "monetary policy can't print babies", and one day or another as our workforces accelerate their decline it may be hard to sustain positive growth. Maybe there are some realities looming out there that we are just not ready or able to accept yet.


But, going back to Renzi, the initiation of sovereign bond purchasing type QE will surely mark the beginning of a Japanese turn in ECB policy. It may start with just 400 billion, but it could then grow and grow, especially if the structural weakness in domestic demand continues to exert a downward pressure on prices even despite the money printing. So just who might benefit from this? Well, you don't have to be excessively astute to see that Italy would be prime candidate. The country currently has a gross government debt to GDP ratio of around 135%, small when compared to Japan's level of nearly 245% but still it is large and rising, especially if Italy continues to push on its fiscal deficit limits. And they will need to do this since there are no signs that the country's economy - like its Japanese equivalent - can grow any faster than it did before the global crisis without ongoing fiscal stimulus. Pushing the debt upward much beyond the current level without being forced into some kind of debt restructuring would seem to be be virtually impossible, unless........... unless the ECB start to buy the bonds. So could Matteo Renzi, who doesn't seem especially worried by the size of Italy's public debt levels be just the man for the job?



The key to the new win-win strategy would lie in the Renzi's aim getting agreement to increase the country's fiscal deficit (rather than as previously lowering the bond spread) in exchange for structural reforms. Basically any ECB Italian bond purchasing would ease pressure on Renzi in the short term. Mario would "have Renzi's back" provided he complied with the reforms. And if he didn't, well then more than likely he would simply go the way of Enrico Letta.

And to those would argue that all of this goes beyond what the German public have come to expect from Euro Area policy, I would suggest that all of what is about to happen was already evident when Mario Draghi used the famous "whatever it takes" phrase. He meant what he said. As I argued in October 2012, in a post entitled "Taking a Man at his Word":
"The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray [Dalio] argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren’t necessarily doing when they increase their balance sheet) ain’t seen nothing yet. That’s what the “it will be enough” promise means. None of this is in the mandate yet, naturally it isn’t, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you’re crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back."

Friday, August 10, 2012

Is The Italian Elephant About To Break Loose Again?

Market nervousness about Italy has been growing in recent weeks, with the Moody's credit downgrade of the country being only  one of the reasons. A bailout is clearly in the offing, with the only real questions being how and when. While the situation inside his country appears to be deteriorating, Mario Monti has been doing the rounds of European capitals in an attempt to drum up support. While in Helsinki he raised an eyebrow or two when he warned that without a serious plan to bring down interest rates disaffection with the euro in his country could easily grow to dangerous proportions. Crying wolf, or a piece of insider information? Probably a bit of both.

Italy is in a deepening recession which has now lasted for over a year. Monti himself  has ruled out the possibility that he could continue in office after next spring's general elections, while at the same time Silvio Berlusconi is constantly hinting that he would not be averse to accepting prime ministerial office again, should his country need him. All of which makes me ask myself just over a year after my "Is Italy, Not Spain, the Real Elephant in the Euro Room?" post, whether in fact the currently chained beast is not about to break its tethers and go for a crockery breaking rumble round the Euro living room.


What follows is a summary of a revised version of a presentation I gave in Cortona last autumn. I have put the presentation online here.

Low Growth And High Debt, A Highly Combustible Cocktail

Just as I highlighted in the case of Portugal in my recent post, Italy's problem is long term growth. This is not a passing phenomenon, but one which has been getting steadily worse over decades. Italy has lost growth at a pace of about one percent a year over the last four decades. If the pattern continues Italy GDP will drop over this decade and continue to do so for as far ahead as the eye can see.



To give us an idea of what this means, Italian GDP at the end of June was at the same level it first reached in the second quarter of 2003. If the current recession continues as forecast by the Italian government during this year, by December we will be below the GDP level of December 2000, which is another way of saying that it will be below the level first attained some 12 years earlier. If the recession is slightly deeper that the current government forecast, and continues throughout 2013 (certainly not an excluded scenario) we might even arrive at levels first seen in the late 1990s.  In the meantime the country's population will have risen from 57 million to 61 million, hence GDP per capita will have fallen substantially. This is not a situation either to be taken lightly, or one which it will be easy to turn around.

There are a variety of reasons for this sharp drop in growth momentum. Some of the reasons are undoubtedly, as I will argue demographic. Others are associated with the loss of international competitiveness experienced by the  Italian economy since entering the European monetary union.

Once clear indication of the extent to which the deteriorating growth outlook is associated with cometitiveness loss is to be seen in the correlation between worsening growth performance and the deteriorating current account balance.


Double Dip Recession

Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009.

After an 18 month recovery, the economy again fell into a second “double dip” recession around the middle of 2011, after a surge in borrowing costs forced the government to apply stringent austerity cuts in an attempt to recover investor confidence.


In the three months up to June GDP contracted for a fourth straight quarter, falling by 0.7 percent over the previous quarter. We don't have the detailed breakdown from the statistics office yet, but it seems clear the contraction was again led by sharp falls in consumption and investment as concerns about the fiscal outlook and the euro area crisis depressed confidence and tightened credit conditions.



It is quite possible that Italy will experience a deeper recession this year and next than most forecasters predict (IMF current 2012 -1.9%), reflecting headwinds from the sovereign debt crisis compounded by Italy’s large planned fiscal adjustment. The government will likely miss its deficit targets and even in the absence of any major shocks to yields, the country’s debt to GDP ratio is surely going to increase significantly over the next few years.

Part of the problem is that Italy's fiscal spending has assumed the importance it has in the country's economy due to the loss of international competitiveness. Reducing the government contribution to GDP in this context only makes the economy fold in on itself. More urgent competitiveness raising issues are needed, ones which will bring quicker results than the ongoing programme of long term structural reforms.

So Just What Do We Mean By International Competitiveness?

The issue of international competitiveness is the one which has perhaps caused most theoretical controversy during the current Euro Area crisis, with one side arguing vehemently that some sort of devaluation is essential, while the other argues equally vehemently that it isn't. In the follwoing slides I propose a slightly new definition of international competitiveness, which is to do with having an export sector which is appropriately large given the median population age of the country concerned.

You can enlarge the slides for easier reading by clicking on them, or alternately you can view them via my slideshare version.



Bottom line:
• Median population age is an important economic indicator
• Populations with high median ages tend to be export dependent
• Export dependency gives a better, more precise measure of international competitiveness.
• An export dependent country is internationally competitive when it has a large enough export sector to drive economic growth.

Italy and The Eurozone Debt Crisis

Total Italian debt is not excessive in comparison with some other countries in the Eurozone, but public debt is the second highest.


Despite having normally run positive primary balances


Italy has run general budget deficits since the 1980s


The problem here is the weight of the debt, the burden of interest payments

Italy Is Now Poised On A Knife Edge


Italian gross government debt to GDP is currently perched just under 123% of GDP. The key factors which will influence the future trajectory are GDP growth, inflation and interest rates. With GDP falling, inflation low and interest rates rising the outlook seems quite problematic. Hence The Problem Of Market Pressure, and concerns about interest rates. Italy is currently paying around 6% for 10 year debt issues, and the average maturity of Italy’s debt is 6.7 years, the lowest level since 2005.

The IMF currently predicts that Gross Government Debt To GDP will peak at 124% in 2013. Any significant slippage on this and debt restructuring becomes inevitable. Investors are worried with good reason. Market responses are not just simple speculation. ECB support is critical, but so are radical measures to increase the growth rate.

Too Big To Rescue?




As stated above, Italy shrank further into recession in the second quarter with a 2.5 per cent annual decline. The 0.7 per cent quarterly fall in gross domestic product, only slightly better than the first quarter’s 0.8 per cent decline, means the economy has now been contracting for over a year, and there is at least another year of the same or worse to come as spending cuts steadily bite and the Euro debt crisis rocks its way forward. The recession will weaken tax revenues and hit jobs and consumer spending, a vicious circle which makes it harder for Mario Monti, who is aiming to cut the budget deficit to 0.1 per cent of GDP in 2014, to meet his public finance goals.


Consumer Confidence and PMI indicators suggest that the Italian government’s GDP growth estimates (of a contraction of 1.2% for 2012 and an expansion of 0.5% for 2013) are way too optimistic . The consumer confidence reading was only just up in July from June's 14 year low, and for the first time since the launch of the PMI services survey in January 1998 firms generally expected output to be lower in a year’s time than current levels.


The employers group Confindustria now forecast a contraction in GDP of 2.4% in 2012. A further fall of 2.0% is not unlikely in 2013 as the European debt crisis worsens. Compared to the other forecasters I would be more negative on the outlook for both private consumption and investment activity. In addition, with a more negative outlook for the euro area economy – destination for 43% of Italian exports — these are unlikely to put in an unexpected stellar performance in 2013.

Unemployment Rising Sharply


Italy's unemployment rate hit a record 10.8 percent in June, up from 10.6 percent in May. There were 2.79 million people looking for work in June, according to seasonally adjusted figures -- a rise of 37.5 percent compared to a year earlier. Youth unemployment dropped from 35.3 percent in May to 34.3 percent. These are not yet anything like Spanish numbers, but they are not to be sneezed at either.


The number of people living in absolute poverty in Italy rose to 3.4 million in 2011, or 5.7 percent of the population, up from 5.2 percent in 2010.Those living in relative poverty for Italian standards were roughly stable at 8.2 million, or 13.6 percent. But among families with no workers and no pensioners, the relative poverty rate rose to 51 percent from 40 percent.

Fiscal Targets Look Increasingly Out Of Reach

The implementation of austerity measures in Italy is likely to have a substantial negative impact on the economy in the coming years. Given its lack of competitiveness, the economy lived off constant demand stimulus from the government. Without this the growth problem is likely to become worse.

There have now been five fiscal packages introduced by Italian governments since July 2011, with the objective of a  cumulative fiscal consolidation of some 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With the majority of the measures concentrated in 2012, there will inevitably be a large negative impact on the economy throughout this year.

Given the deep recession the country will be in over the next couple of years and poor potential growth prospects over the medium- and longer-term, Italy’s public sector balance sheet problems are likely to mount. Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison with many Euro Area countries the governments projection of a close-to-balanced budget in 2014 looks hugely optimistic. A more realistic expectation would be for the deficit to be under the EU 3% level at that stage, but the danger is this could well mean gross debt to GDP will be over 130%. Above the danger mark.



The ECB's role in the crisis both helps and doesn't help, depending on how you look at it. They have been very tardy in acting, and normally when they have done so it is been via half measures which have not got to the heart of the problem. The LTROs are a good example. Italian banks have borrowed more than 283 billion euros from the ECB via the 3 year LTROs and other liquidity operations, but this liquidity is by and large used to either purchase government bonds or buy up their own expiring debt. Buying government bonds is attractive since they pay yields which are far above the ECB lending rates. This difference - the so called "carry" -  helps bank profitability and enables them to recapitalise, but it also means that interest rates charged to small business clients rises as they need to compete with the government for funds. Despite the fact that such practices make the banks more "joined at the hip" than ever with their sovereigns, and that their exposure to losses should the Italian sovereign eventually have to restructure rises, they remain attractive because the risk weighting and hence "capital consumption" of public sector lending under the Basle rules remains absurdly low. This is where the real private sector “crowding out” comes.


Banks increased their holdings of the country’s bonds by about 78 billion euros in the first six months of 2011. This forms part of the “nationalisation” of Europe’s sovereign debt markets. Foreign investors cut their holdings of Italian government securities by 18 percent in March from a year earlier, according to the Bank of Italy. In the same month Italian banks boosted them by 39 percent.

Meanwhile, as we can see in the chart above, the rate of new lending to the private sector has been falling steadily, to both households and corporates. As I say part of the problem is that as the recession deepens the credit risk perception of Italian households and companies deteriorates,as the ECB pointed out in their latest monthly report.

The report immediately produced criticism from the Italian consumers’ association Codacons, who complained that the ECB itself had not found a solution to this situation. “If companies are insolvent it’s because banks are strangling them, denying them credit,” Codacons said. Coldiretti, the Italian agricultural association, also estimates that 60 per cent of companies in the sector risk being starved of credit as they face interest rates that are 30 per cent higher than the average of other sectors.

This problem is more complex than it seems. It is not so much a question of credit being strangled, but of demand being strangled as austerity bites. Companies who cannot sell profitably are a high credit risk. There is demand globally, but as I am saying Italy is insufficiently competitive to take advantage of it. Bottom line, the high cost of financing Italian government bonds is pushing up longer term interest rates, and discouraging investment, and this is an issue the ECB could address, by directly buying commercial paper, for example.

Easing In The Bailout

The possible Italian bailout is fast becoming a tricky political issue. The technocratic government of Mario Monti would like to get an MoU agreed before handing the country back to the politicians.


The request for bond buying would involve ECB secondary market purchases as well as primary market purchases by the EFSF. It would also involve a Memorandum of Understanding which would undoubtedly contain strict conditions and an implementation supervision mechanism. The ECB would surely also have a say in those conditions if bank bond purchases were to form part of the package.  Indeed, the ECB has only this week in its August bulletin made clear what it thinks is required. The Bank suggests countries with high unemployment need to “abolish wage indexation, relax job protection and cut minimum wages”. The bank is not impressed with the Italian labour reform, which is too little too late, and thinks direct wage cuts are now the only workable remedy.


Unsurprisingly, many Italian politicians are highly reticent about being seen to hand over their country’s future to an institution with such views, which if implemented would be massively unpopular in the country, so pressure is mounting for Monti not to ask for help. That having been said, the country really has no alternative if it wants to stay in the Euro.

Is Italy Facing A period of Growing Political Instability?

But this is just it, exactly how committed is the Italian political class to staying in the Euro? Certainly it is the one country on Europe's periphery where you can hear speeches from politicians with serious followings questioning whether there are not alternatives. Indeed Mario Monti warned on just this point during his recent Helsinki visit. "I can assure you that if the (bond yield) spread in Italy remains at these levels for some time then you are going to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he said.


He was, of course, referring to the ambivalence of Silvio Berlusconi on the Euro issue, and the outright hostility to the common currency displayed by the rising (5) star of Italian politics, Beppe Grillio. “After me the populists”, as Monti once said.


A lot of these statements can be read as brinksmanship, but as BofA Merrill Lynch foreign exchange strategists David Woo and Athanasios Vamvakidis warned in a July 10 report, investors “may be underpricing the possibility of voluntary exit of one or more countries” from the currency bloc. And these countries may not be the ones most widely talk about, like Greece or Spain. It was Italy, the euro area’s third-largest economy, which they found would enjoy a higher chance of achieving an orderly exit than others and would stand to benefit from improvements in competitiveness, economic growth and balance sheets.

Woo and Vamvakidis employed a variant of game theory and found that while Germany could “bribe” Italy to remain in the bloc and avoid the fallout from an exit, its ability to do so is limited. That’s because Italy has more reasons than Greece to leave so any compensation could become too expensive for Germany and Italians may be even more reluctant than the Greeks to accept the conditions for staying.

Interestingly enough in this connection Nomura's Jens Nordvig and Nick Firoozye (whose excellent work on Euro break up dynamics unfortunately did not win them the Wolfson Prize) argue in their afterthought essay (Wolfson: What we learned about the future of Europe, Nine specific lessons from the Wolfson Economics Prize competition) that one of the things they learnt from doing the spadework was the following.
"We have constructed a data base of the relevant liabilities for each Eurozone country, and our calculations show large relevant external liabilities in Greece, Portugal, Ireland and Spain. This analysis highlights that currency depreciation following exit from the Eurozone would substantially increase the external debt burden of these countries...."

"Meanwhile, we note that estimated balance sheet effects following exit in the case of Italy and France, are substantially smaller than in other peripheral countries, mainly as a function of the prevalence of local law obligations (which can be redenominated) within external liabilities. It follows that policy makers and investors should pay close attention to the size of balance sheet effect (not only to standard competitiveness and the trade effects) when thinking about the macro impact of specific exit scenarios".
So, summing up briefly, while the Monti Government’s structural reforms are obviously a step in the right direction it is unlikely they will go either far enough or fast enough to significantly lift the country’s potential growth rate from its present lamentable level.  Further, as the April 2013 election approaches  the growing  popularity of new political movements like Beppe Grillo's Five Star one could easily  lead to the kind of political fragmentation already seen in Greece - Italy has hardly been a model example of the two party system -  making the traditional political forces which back the Monti Government even more reluctant to accelerate the adoption of far-reaching reform.

And going beyond April, the political arithmetic of a post Monti government looks complicated, making the kind of stability needed to advance what the population may well see as "harsh" reforms unlikely. In other words, as Monti says, when I go watch out for the populists!

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".