Italy Economy Real Time Data Charts

Edward Hugh is only able to update this blog from time to time, but he does run a lively Twitter account with plenty of Italy related comment. He also maintains a collection of constantly updated Italy economy charts together with short text updates on a Storify dedicated page Italy - Lost in Stagnation?


Monday, December 26, 2011

Italy Braces Itself For The Full Monti

The Italian government, Mario Monti informed the country's parliament last Thursday, is now planning to concentrate its attentions on achieving economic growth. A timely decision this, since the statistics office announcement a day earlier that the country had once more fallen back  into recession, while not being a surprise nonetheless does constitute a cause for concern. Not that Italy is any stranger to recession, since the country has now had five of them since entering Europe's Monetary Union at the turn of the century. In fact the Italian economy has now contracted in eight of the last 15 quarters, and GDP is back in the good old days of 2003, stuck below the level it first attained in the first three months of 2004. And of course it is now going backwards in time again. Depending on the depth of the recession now being provoked it is touch-and-go whether the economy might not at some point even revisit levels last seen in the closing years of the 1990s. And remember, this is not deflation ridden Japan, this is real, not nominal GDP we are talking about here. So far Italy hasn't been experiencing deflation, or at least not yet it hasn't.

All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don't have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.



Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years  up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.


Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.


Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004  and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won't be easy to address.




It's The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.




Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was - and has been for some years - on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs - like so many of the countries on the EU periphery -  is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.




Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).


Retail sales have been falling since 2007.


And construction spending has been one steady slide down.


And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.




No Boom, No Bust


So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy's export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.




With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country's recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the "optimistic" camp on the question of the country's ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay's Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.



But then imagine the average finance cost of Italian debt rises, and stays high. In this case  the only way to compensate  is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what "knife edge dynamics" really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that  yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels "lock in" - the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.




No Way Back Home

But again, let's do another thought experiment. Imagine I am right, and  Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy's case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.



Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn't the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian "coupling" with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited  to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be "bye bye Euro" (assuming the common currency still exists that far up the road).

It's All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the "knife edge trap" around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.


One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth - a factor the "structural reform answers all our problems people" don't seem to have given enough thought to.



The Monti government needed  just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is  widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.




Till The Dowgrades Fall


So the "Full Monti" effect now seems to have  been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB  - with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy's rating to A+ on October 8) on December 15 to brace for a further debt downgrade after concluding that a "comprehensive solution to the eurozone crisis is both technically and politically beyond reach". And to complete the set, Moody's, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable  The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe's leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy's citizens who are subjected to the Full Monti, Europe's leaders may also find themselves with their credibility stripped naked.

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

Wednesday, August 17, 2011

The Policymaker's Fear Of The Italian Penalty Shot

“While the impact of service-sector liberalization and privatizations may be positive on medium-term growth, the budget cuts are likely to have quite negative effects on the short-term GDP dynamic. We expect Italian GDP growth to slow to close to zero in 2012 and 2013.” Giada Giani, Citigroup

According to one anonymous German official speaking off the record to reporters from Der Spiegel, "a country like Italy can't be saved". We will have to trust that he was referring to the country's size when he made the statement, and not its existential core. If he was, he may well be right, at least under the Euro Area's current institutional arrangements. Let's take a quick look at why.

The ECB Backstop Works For Now

The Italian debt markets are a lot calmer this week than they were the week before last. Evidently there is a simple explanation for the phenomenon, and that is that the level of Italian bond yields is now more or less completely guaranteed by the European Central Bank (the ECB). Systematically and meticulously, the Italian ten year bond yield is being maintained at or around the 5% level by a team of dedicated bond traders in national central banks dotted around the Euro Area.

The process whereby this result is achieved is not that dissimilar to other more common central bank interventions, for eaxmple to target a certain exchange rate, or a given overnight interest rate. Basically, when the yield rises above a given threshold the ECB's representatives simply step in and buy bonds. This happened last week to the tune of some 22 billion euros, with bonds being acquired from a set of 5 EU peripheral countries, although we don't know how the purchases were broken down at national levels. One thing was for sure, there were a hell of a lot of Italian bonds tucked in there somewhere.

The problem for the bank now is that once you initiate a programme like this, there is no easy way to stop. Despite many voices who argue the contrary, Italy's problem is not simply a short term liquidity one (funding a deficit), it is a long term solvency one (servicing an enormous pile of debt and growing at the same time). While the country has long maintained a primary surplus, the weight of the debt has drifted steadily onwards and upwards. Italy is caught in a conundrum. With low growth you need inflation to be able to make the books balance, but this excess inflation makes the country's competitiveness problem steadily worse. If you implement the reforms needed to make the economy more competitive then you don't get the inflation, and if you take away the deficit in the meantime then you simply don't get growth. This is a zero sum game in which all the numbers don't add up.








At the push of an ECB "buy" button, Spanish and Italian sovereign bonds have effectively been taken out of the markets, and it is now hard to see how (without some sort of restructuring or other) they can now ever get back in again.

In ceding to pressure from Europe's leaders to take this decision, the central bank has now gotten itself locked onto the horns of a huge dilemma, and they are going to have great difficulty finding a way to extract themselves from it. Monsieur Trichet has lodged his finger well and truly inside the wall of the dike, and should he even momentarily take it out again, the whole structured could easily rupture, with many of the things we now know and love getting carried away in the ensuing flood.


Of course, the mere threat that he might one day do this does serve to concentrate all the various minds involved, but what is involved is a form of brinksmanship which could in itself one day become a problem.

A glimmer of what the bank is now getting itself involved in can be seen in last week's ECB balance sheet reading, since it grew to the year-to-date high of 2.073 trillion euros last, largely as a result of increased lending to eurozone financial institutions and additional sovereign bond purchases.

The balance sheet was up by 68.736 billion euros over the previous week, and 119.94 billion euros over the same period one year ago. In part the balance sheet surge was due to an increase in net lending to credit institutions (which increased by 98.3 billion euros to 393.3 billion euros). And in part it was up due to the 22 billion euros spent in bond purchases. Curiously the weekly fixed term deposit levels remained unchanged at 74 billion euros (the quantity spent in periphery bond purchases to date), which sort of settles the issue of whether the bank were going to "sterilise" the new purchases, or create additional money to pay for them. For the time being at least they seem to be doing the latter, since going by the size of the banks current account holdings (which jumped to 286.783 billion from 159.814 billion euros a week before) they seem to have offset the purchases through money creation.

Basically central bank bond purchase intervention is deemed to be "neutral" in monetary policy terms if an equivalent quantity is drawn back from the banking system by attracting new term deposits at the central bank. That the bank may be carrying out a "money printing" exercise (and especially one to monetarise the debt of certain countries in particular) is raising fears of impending inflation. My feeling is that, in the context of heavily over a leveraged private sector and congenitally weak domestic demand, this is not a real concern at present for the Euro Area. I think the ECB's own inflation alert was always overdone, since most of the inflation we have seen of late has either been imported (via rising energy and commodity prices) or adminstratively generated via consumption tax increases. There has been very little in the way of second round effects.

The real worry then should not be inflation, but whether or not the Italian government will ever be in a position to honour the bonds in full, and on time. At the present time this is only a theoretical question, since additional bond purchases can always enable the Italian state to meet its obligations, with the ECB facilitating debt rollovers by using the commercial banks as proxies in the primary markets. But just how deep in do you want to get? At the present time the bank owns something like 20% of outstanding Portuguese, Irish and Greek debt. 20% of Italian debt would be something like 380 billion euros, a volume of bonds which would already be difficult to pass over to the EFSF (or its heir the European Monetary Fund). But in this case the force of tradition is not strong, and there is no real reason why the bank need stop at 20%. The sky could be the limit, and the ECB could be transformed into the new Bank of Japan, effectively light years away from the earlier visions of the Bundesbank founding pioneers. And, of course, we would all be into one of those processes which can go on for just as long as they can.

The Balanced Budget Ammendment

At the heart of the recent ECB decision lay something known as the balanced budget ammendment. First introduced in Germany in 2007, this is a constitutional change which (in the German case) makes a deficit of over 0.35% of GDP illegal as of 2016. One of the conditions the ECB imposed on Italy was that they also change their constitution, but in this case outlawing deficits as of 2013. Effectively, and at a single stroke, this brings to an end a whole era of Keynesian counter-cyclical fiscal policy and economic management. So the implications are large, and hard to separate from the rapidly ageing population phenomenon.

While it was the size of the latest package of cuts which hit the headlines (Rome orders €45bn in cuts and taxes), the key issue was really the balanced budget ammendment, since this has one clear implication: as of 2013 there will be no new bonds. So at least now the outer limit of ECB exposure is a known fact.

Chronicle Of A Crisis Long Foreseen


While the Italian crisis may have crept up on markets all at once and unexpectedly, issues about the sustainability of Italian debt are not new. As FT Alphaville's James Coterill noted when the latest wave in the Italian crisis broke out: "In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. It was always Italy. High-debt, low-growth, Italy".

Exacty, Italy was always the greatest worry on everyone's minds, including the ECB's. Indeed, the now long forgotten minimum rating requirements for collateral posting at the bank were first muted by them with precisely Italy in mind. I myself wrote one blog post after another (see links below) warning of the danger which was looming, buried in Italy's toxic combination of low growth, rapidly ageing population and high accumulated debt. It was simply a crisis waiting to happen, and now it has. As the New York Times' Landon Thomas noted in the Blog Prophet of Eurozone Doom article he wrote about my work, "Mr. Hugh’s demographic thesis is not airtight: in fact, it was Italy, not Greece, that attracted his early attacks. But Italy, perhaps because its overall debt level was already so high and its population was older, pursued a policy of greater fiscal rectitude than its neighbors and avoided a real estate bubble".

Not airtight, but nearly-so it seems, since behind the short term obsession with fiscal rectitude there lie the longer term preoccupations about solvency and debt. And here Italy (and eventually Japan) jump right back into the cockpit. As Landon mentions, Italy didn't have a housing boom worthy of mention, so private debt didn't surge during the first decade of the century, and during the crisis Finance Minister Tremonti pursued a policy of flying under the radar by keeping deficit spending low. But now short term deficit issues are waning, and longer term solvency questions are surfacing in the wake of the renewed Greek crisis. Thus, while historians of the future may well struggle to understand just how it was that a simple fiscal deficit bailout programme was so badly handled that Greek sovereign debt shot up from around 110% of GDP entering the crisis to around 170% by the end of the "rescue" period (and this without even having enjoyed a real housing bubble, ie with a private sector that was not massively in debt), the Italian case will raise few eyebrows, since every thinking economist had seen it coming for so long (Japan too, see my Italy blog here, here, here and here).


Low Growth and Ageing Workforce Are A Troubling Backdrop

Italy's problem is not its fiscal deficit, in fact in every year since 1991 Italy has run a cyclically adjusted primary balance (that is before interest payments are taken into account), it is the weight of the accumulated debt burden and low growth. The country's trend growth rate has been falling for decades, and during the first decade of the present century it only managed to grow at an average rate of about 0.6% per annum.




Even though the quarterly GDP growth rate accelerated slightly in Q2, and reached a quarterly rate of 0.3% (up from the 0.1% expansion achieved in the first three months of this year), the slowdown in core Europe, and the readings on the most recent PMIs leave little doubt that the respite will be short lived. At this point even the current IMF forecast for modest 1% GDP growth in 2011 is looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.


The worrying thing is how Italy has been able to get so little growth out of so much. This is especially the case when you take into account the fact that during the last decade the country's labour force grew steadily, following the arrival of several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).



During this time the labour force grew by about a million:


while employment was up by around 1.5 million.



Yet GDP barely rose. In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption. The ideal combination would be to see both output and employment growing in tandem, but with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".




Slamming The Debt Brake Pedal Down To The Floor Won't Work

Despite the fact that the real leverage M Trichet now has over the Italian government is being exercised in order to obtain the constitutional change required for the balanced budget rule to be put in place, the severity of the fiscal tightening that Italy will now experience should not be taken lightly. In the first place something like 45 billion euros in new cuts will be implemented in 2012 and 2013, and this will be on top of the previously agreed package of 47.8 billion euros in cuts between now and 2014 agreed in the July budget.

In addition Italy will now aim for a general budget deficit no greater than 0.2% of GDP in 2013 (Germany will not achieve this result till 2016), and will maintain that ceiling into the indefinite future. Basically, this will mean the post 2012 Italian budgets will need to aim for an average primary surplus of just under 5% of GDP during the subsequent years, as the weight of the debt is gradually ground down, and the burden of interest costs reduced. This is a difficult, but not impossible task.Between 1995 and 1998, when Italy’s undertook its maximum effort to enter the monetary union, the average primary surplus was 5.0% of GDP. However, during the second half of the 1990s Italy was benefiting from both decreasing interest rates and also from the depreciation of the Lira. In addition the Italian government also implemented a significant privatization programme which helped to reduce the debt/GDP ratio. Most of these positive tailwinds will not be available this time round.

As Deutsche Bank analyst Marco Stringer puts it: "While there are no doubts that Italy needs to maintain a very prudent fiscal policy, there is a risk that an excessive fiscal consolidation could be counterproductive were it to have a significant negative effect on growth".

There is a very real possibility that Italy's fiscal consolidation, like Greece's, is so sharp as to be counter-productive, with the low inflation, low growth and revenue shortfalls making it extremely difficult for the country to reduce to debt to GDP level, even if the ECB maintains 10 year bond yields around 5%. Writing in the Financial Times, International Monetary Fund managing director Christine Lagarde makes exactly this point. “We know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustments must resolve the conundrum of being neither too fast or too slow. Shaping a Goldilocks fiscal consolidation is all about timing. What is needed is a duel focus on medium-term consolidation and short-term support for growth and jobs", she said.

So we really do now have a very high risk stand-off, with Monsieur Trichet and his colleagues holding the whip hand for the time being, as the threat to take the finger out of that dike concentrates attention on the issue in hand. But this upper hand has a definite sell-by date looming if the implementation of the debt-brake principal in a context of global slowdown (or recession) proves too severe for Italian voters to accept. Then the Italian politician's fear of the penalty shot from someone on his own side might just become stronger, despite his apprehension before the technical superiority of M. Trichet's footwork. In which case, someone should remind them over at the ECB that, as Paul Krugman puts it, "once once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors". As the United States discovered in Vietnam, it's easy enough to get yourself bogged down in a mess, but a lot harder to extricate yourself from one subsequently.

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

Tuesday, August 16, 2011

Going Dutch - One Possible Solution To the Euro Debt Crisis?

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing -- after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago -- ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe's leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor's to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet's third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe's financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe's banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained "no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong".

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:



“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.


The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No..., No..., No..., No..., No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states -- and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.


The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone -- as it is now -- might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.


So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.


The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.



In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.




The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.




Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke.




No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.




And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.




Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.


This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title "The Euro and the Scalpel"


Appendix - The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I'm German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.



These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.



Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.







It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

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

Monday, July 25, 2011

Recession Warning On Europe's Periphery

As Europe’s leaders struggle to convince markets that their Greek debt problem-resolution-proposals are actually viable, and will really do the trick, last week's flash PMI readings seem to have attracted rather less attention than they might. Nonetheless, the fact of the matter is that it is steadily becoming clearer that the current slowdown in Eurozone economic growth is turning into something more than just another one of those pesky “soft patches”. The pace of economic expansion in core Europe has slowed dramatically, falling back in July for the third consecutive month, according to the latest flash PMI. Commenting on the flash results Chris Williamson, Chief Economist at Markit said: “The Eurozone recovery lost almost all of its momentum in July, recording the weakest growth since August 2009 when the recovery first began. Excluding the financial crisis, the July survey was the most downbeat since the Iraq war in 2003, and consistent with a flat trend in quarterly gross domestic product.



In fact the rate of expansion – the composite indicator registered just 50.8, only slightly above the dividing line between growth and contraction - was the lowest since August 2009, when the recovery was just starting out. More importantly (for the longer term) new business coming in showed only a very marginal increase in July, registering what was the smallest rise since demand for manufactured goods and services first started to return to growth back in September 2009. Levels of incoming new business fell in manufacturing for the second month in a row, declining at the fastest rate since June 2009 – with new export orders actually falling for first time since July 2009.



What this means, of course, is that the slowdown has now extended, spreading deep into the heart of the core, with both services and manufacturing in both Germany and France affected.



The German composite index fell to 52.2, from 56.3 in June, and while the latest reading still remained comfortably above the 50.0 no-growth value, the month-on-month index fall of 4.1 points was the largest since the November 2008 post Lehman drop. Tim Moore, Senior Economist at Markit said in his report “Almost in the blink of an eye, German private sector output has gone from rapid growth to a slow crawl.

But even as growth in the core economies approaches stall speed, out on the periphery a new recession seems increasingly on the cards, and most importantly in countries like Spain and Italy which have so far managed to keep their heads just above the waterline. Growth in the second quarter of the year looks likely to have been minimal in both cases, and the outlook for the third quarter suggests we are entering a bout of economic shrinkage.



The PMI readings also coincide with the impression offered by monetary indicators.



As Henderson Global Investors’ Simon Ward points out, in late 2010, while real (ie inflation adjusted) current bank deposits were contracting in Spain and Italy, they were still growing robustly in both Germany and France, implying a solid economic growth economic outlook in the core for the first half of 2011 (this monetary indicator is often thought to give an indication of activity with a 6 month lag).

But currently, as can be seen in the above chart (which shows rates of six monthly growth) real deposits have even started to contract in the core, while in Italy the rate of shrinkage has accelerated considerably, suggesting that the earlier “two-speed” Eurozone recovery may now be about to give way to a period of much more generalised weakness, reinforcing the impression given by the PMI order indexes. What is most striking is the way Italian M1 deposits have been contracting much more strongly than Spain’s have of late, although this development should not take us completely by surprise, since, as I have been consistently pointing out (see here, here and here) it has been clear from both real and survey data for some months now that Italy was heading towards recession again.



And looking at the second monetary chart that Simon provides, it is evident that the weakness in Spain and Italy forms part of a much more general contractionary phenomenon on the periphery, but then I imagine that the idea that Greece and Portugal might be in recession comes as a surprise to no one.

Part of a Bigger Global Picture

Of course, the vulnerability we are seeing on Europe’s periphery is being played out in the context of a global economy which is itself clearly losing momentum. This generally weakening in global growth has been clear from the evolution in the global manufacturing PMI for some time now.



And the latest China manufacturing flash PMI (which showed contraction for the first time since the middle of 2010) suggests the ongoing pattern will be once more confirmed in July, with global manufacturing moving closer to the critical 50 dividing line which marks the frontier between growth and contraction.



Even more importantly the Chinese export order component (which could be considered as a long leading indicator giving us information about possible activity levels three to six months from now) reinforced the idea that the slowdown is likely to be extended in time.



This impression (of an extended period of lower growth globally) is also confirmed by the business expectations component of the German IFO. I would about anticipating an early termination of the slowdown till we see some real sign of sustained improvement in Chinese new export orders and a solid uptick in IFO expectations.



So Why Don’t We All Be Just That Little Bit More Vigilant?

Where does all this that leave Europe in policy terms? Well, in principle recent developments in the real economy should present the ECB with significant monetary policy dilemmas, given the risks to the integrity of the monetary union that could result from a combination of reform/recession weariness out on the fringe and bailout fatigue in the core. Evidently the slowdown will make it harder to meet deficit targets in Spain and Italy, and will most likely mean there is a need for new measures which will become harder and harder to sell to voters, while any deterioration in the jobs market in Germany (we should be watch the unemployment numbers in Germany in the coming months) could well make bailout contributions harder to drum up. As John Hussman put it in a note to investors this morning:

"As I've noted several times in recent months, bond market spread imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It's Different, "Overt domestic default tends to occur only in times of severe macroeconomic distress." The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbours at a cost to their own citizens".


So in theory what these leading indicator readings should be telling us is that we should expect little more in the way of rate rises during what remains of 2011. Continuing to raise rates into an economic slowdown where there are clear risks of financial instability would not seem to be sound monetary policy.

In addition, given the way the pace of manufacturing input price inflation now seems to be cooling rapidly (see chart below), it would not be surprising to see a change the wording of the risk assessment for price stability from ‘on the upside’ to ‘balanced’ at the next meeting. This would avoid a lot of potential communication difficulties in the months to come, and would open the door up to a much more flexible interest rate policy.



One critical point to grasp is that the ECB decisions themselves have now become one of the main factors which will influence the outcome of the slowdown, not simply via the standard monetary policy path on Europe’s core economies but via the impact its decisions will have on policy sustainability on the periphery, and though this channel on the level of global risk sentiment.

In this sense ensuring economic growth is not the only distraction which could divert the ECB’s attention from its principal mandate in defence of price stability, since there is also debt stability to think about too. Recent days have show that large peripheral economies like those of Spain and Italy, far from having totally decoupled from the smaller and weaker countries, are now once more being drawn back into the maelstrom.



In particular Italy’s government debt to GDP level of 120% has been attracting growing attention. Simple calculations show that just to stabilise debt at this level with the previous prevailing interest rates the country needed a 3% annual growth in nominal GDP. Now, of course, they are likely to need slightly more. But real GDP growth this year will be significantly under 1%, while all those earnest efforts by the ECB to push the country’s inflation rate down below 2% will simply serve to help nudge the debt level upwards, in the process raising the premium investors will ask to buy Italian debt, with the implication that next year the country will need an even higher rate of nominal GDP growth, and so on, and so forth.
And the situation is Spain is hardly better, with 85% of mortgages being attached to variable rates, pushing Euribor upwards simply starts to weaken the hitherto comparatively robust performance of the bank mortgage books, while the slower economic growth will make government deficit targets even harder to maintain.

So really, the issue is not whether the ECB was right to go ahead with this months rate rise given its main mandate, the issue is whether members of the Governing Council could by any chance prove themselves sufficiently flexible in the future to change their discourse in the face not just of Greek default woes, but also of heightening recessionary and debt management risks? In his report just before the last rate meeting, Deutsche Bank’s Gilles Moec argued that the situation was “not bad enough” for the Bank not to raise. I wonder if the deterioration we have seen since that time makes it “now bad enough”? Just how bad do things have to get for us to reach that point, and just what is prudent and what is risky behaviour in current circumstances? Certainly Council members need to be vigilant, but in particular they need to be vigilant that their attempts to avoid one problem do not inadvertently generate another, even more difficult to handle, one.


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