#127: Quantum of risk, part three

THE ITALIAN GAMBIT

Here’s a test of the imagination. First, picture someone asking you to write off a debt of €100,000 that he owes you. Next, picture this same man, with his next breath, asking if you will also act as guarantor of his next overdraft. Oh, and he would like to rewrite all the rules governing the financial relationship between you, too.

Though this stretches the imaginative faculty, it’s pretty much what the incoming Italian government is asking of the European Central Bank (ECB). As well as agreeing to write off €250bn of Italian public debt, the ECB is expected to watch benignly as Italy then embarks on a new fund-raising exercise, implicitly guaranteed by the ECB.

The chances of the ECB agreeing to this must be close to zero, not least because of the precedent that it would set for other Euro Area (EA) borrowers.

Yet it seems equally unlikely that the new coalition in Rome will back down over ambitious plans seemingly endorsed in large numbers by the electorate.

In short, what we have here are the makings of a full-blown EA financial (and political) crisis, yet the markets have seemed neither stirred nor shaken by it. Right now, the apparent softening of the Trump line on trade with China seems to be the only game in town. It may be a characteristic of markets that they can focus on only one issue at a time, and this might help explain seemingly relaxed reactions to events in Italy.

It doesn’t help that a media focus on “populism” is obscuring what is really happening as a new coalition prepares to take office in Rome.

The aim here is to investigate what might be called ‘the Italian gambit’. The main conclusion is that this situation is a direct result of systemic weaknesses within the Euro.

SEEDS – the Surplus Energy Economics Data System – is used here in two main ways.

First, SEEDS tracks the long-running erosion in prosperity which has led Italy to this juncture, discrediting the political establishment and paving the way for radicalism.

Second, SEEDS is also deployed to calibrate the degree of financial risk posed by Italy.

All change in Rome

Even if the fundamentals are improperly understood, what ought to be influencing bond markets now is a dawning recognition that genuine political change is on the cards. The sparring is over, and Italians really are about to get a radical new government, formed by a coalition of two parties, the Lega and the Five Star Movement (5S).

Both are often labelled “populist”, but the term preferred here is the more neutral ‘insurgent’, meaning ‘challengers to the established order’.

The new government certainly seems set to merit the ‘insurgent’ label, if what we know so far is anything to go by. Apparent plans to deport as many as 500,000 undocumented immigrants are likely to prove highly controversial, as are proposals for rolling back sanctions against Russia. The new administration may be hoping that its migrants plan might push its EU partners into taking a larger share of immigrants for whom Italy has been the primary point of entry. Relaxing or even scrapping sanctions on Russia, on the other hand, amounts to a direct challenge, not just to the EU but, implicitly at least, to the uneasily-shared stance of Europe and the United States.

But the real meat in the policy sandwich is economic and fiscal. What the new government appears to want is a major house-cleaning exercise, intended as the basis for radical reform of taxation, public expenditures and debt.

Essentially, the Lega and 5S are planning a repudiation of the Euro Area doctrine of austerity. Just one of the many snags with this is that Italy is already one of the most indebted governments in the EA.

On the revenue side, the coalition proposes a flat tax, levied at 15% and 20%, and offset by a flat €3,000 tax deduction. Planned increases in excise and sales taxes are to be scrapped, which alone will cost about €12.5bn (within current revenues of €800bn). A key spending plan is to introduce what looks a lot like a universal basic income (UBI) of €780 per month for poor families. The coalition is also likely to rescind the intention to start raising pension ages.

All of this is likely to push the fiscal deficit sharply higher, which is why the government will seek a relaxation of EA rules which restrict budget deficits to 3% of GDP. But this proposal is just the thin end of a wedge of challenges to the EA system.

Most strikingly, the coalition partners have called on the ECB to “forgive” (meaning write off) €250bn of Italian government bonds. They also plan to start issuing short-term credit notes (sometimes labelled ‘mini-bots’), which means that Italy will be adding to its public debt at the same time as asking a big creditor to let it off the hook.

How did things get to this impasse?

The Euro – faults in the system

We should be in no doubt that the challenge to the architecture of the Euro system being posed by the incoming Italian government needs to be taken extremely seriously.

Fundamentally, this situation is a direct consequence of weaknesses in the Euro system. From the outset, a model which combines a single monetary system with a multiplicity of sovereign budgets has always been an exercise in economic illiteracy, and a clear case of political ambition trumping economic realism. Putting politics ahead of economic reason usually comes at a price – and, for the Euro system, Italy is about to present the bill.

Here’s how the faults in the Euro have led Italy to where she is now. Over a very extended period, Italian competitiveness has eroded. Before Italy joined the Euro in 2002, gradual devaluation acted as a cushion, shielding Italians from the worst effects of diminishing competitiveness. With each successive decline in the value of the lira, living standards decreased slightly (which is a stealthy sort of “austerity”), in line with rises in the cost of imports. But this very modest (and, incrementally, barely-noticeable) inflationary impact on prosperity was more than countered by falls in the relative prices of Italian goods and services, supporting jobs and activity in the Italian economy.

Abruptly, however, joining the Euro took away this long-standing cushion of stealthy devaluation. Critically, loss of the ability to devalue was not countered by the automatic stabilisers customarily provided by the combination of monetary and fiscal systems.

These stabilisers work like this. If, for example, the economy of northern England were to deteriorate, whilst that of the south was prospering, southerners would pay more tax and receive less benefits, whilst the reverse would happen in the north. This process creates transfers between prospering and struggling regions which help to counter imbalances created by divergences in competitiveness. Most importantly, this process happens automatically in any properly-functioning monetary area, and does not require decisions by government.

No such automatic process exists in the Euro area. Denied the ability to devalue, and without the cushion of automatic stabilisers, the only way that a country like Italy can defend its competitiveness is through a process of internal devaluation, whereby the costs of production (essentially, wages) are reduced. This process has become synonymous with “austerity”, and the unmistakable lesson of recent political events is that Italians want no more of it.

Prosperity and risk – the SEEDS reading

SEEDS analysis underscores an interpretation based on dwindling prosperity within the straitjacket of monetary inflexibility.

According to SEEDS, average prosperity in Italy peaked in 2001 (on the eve of Euro membership), and Italians have been getting poorer ever since the country joined the Euro. Prosperity in 2017 is put at €24,130 per person (compared with GDP per capita of €28,300), and the average Italian is now €2,680 worse off than he or she was ten years ago. The trend decline in average prosperity is 0.4%. Though not drastically out of line with what is happening in some comparable countries, this is certainly bad enough to sustain popular discontent.

From this, you can see why developments in Italy are likely to become a direct challenge to the Euro, even though the incoming administration in Rome hasn’t – quite – committed itself to debating Euro membership. Assuming that neither the ECB nor the new Italian government gives way, what may very well result is a rethink of Italy’s membership of the single currency.

Nothing encompassed by this confrontation can possibly stop at the Italian border, making this a challenge which far exceeds the implications of “Brexit” for the EU.

SEEDS and the quantification of risk

As well as underlining the decline in prosperity which has pushed Italy to this impasse, SEEDS can also calibrate the level of risk involved. Interestingly, Italy doesn’t come out too badly on some of the risk metrics applied by SEEDS. But the last of the four metrics contradicts this finding in very serious ways.

For starters, Italy does not score too badly on financial exposure tests. With aggregate prosperity of €1.46 trillion – 15% below reported GDP – debt, at 245% of GDP, equates to 288% of prosperity, a number that is not particularly high compared with similar economies.

Likewise, financial assets (a measure of the size of the banking system) are estimated at 465% of prosperity (and just under 400% of GDP). This, again, is not a worrying outlier.

Third, and despite its reputation as a highly indebted economy, Italy’s credit dependency is comparatively modest, with annual borrowing averaging 1.9% of GDP over the last ten years. Other countries would suffer a lot more than Italy from any interruption to the continuity of credit.

Italy doesn’t score too badly, then, on three of the four main benchmarks used by SEEDS for risk assessment:

• Debt/prosperity (Italy 288% versus an EA average estimated at 300%)
• Financial assets/prosperity (465% for Italy, against an EA average close to 600%, which reflects very large exposure in countries such as Ireland and the Netherlands)
• Credit dependency – measured in relation either to GDP or prosperity, this calibrates exposure to disruptions in credit flow, a metric on which Italy isn’t badly exposed.

There are, though, two very major flies in this ointment.

First, Italy scores badly on the fourth SEEDS risk metric, which is “acquiescence risk”. What this means is the willingness of the public to support measures which might be both necessary and unpalatable.

Even if it were not already clear (from election results) that Italians have lost patience with anything which sounds like austerity, a decline in prosperity of 12% since a peak as long ago as 2001 can only have eroded voters’ preparedness to go along with the sort of painful proposals which might emerge from conventional politics. On “acquiescence risk”, then, SEEDS puts Italy in a pretty high-risk category.

As well as “acquiescence risk”, the second snag lies in the quality (rather than the scale) of the Italian banking system, where anecdotal evidence suggests a very high level of potential toxicity.

What happens now?

As we have seen, Italy’s central problem is an inability to address competitiveness through conventional devaluation, forcing the country into the painful process of internal devaluation known as “austerity” instead.

Just as monetary rigidity has been a major cause of these problems, it also complicates any search for a solution. Were Italy monetarily sovereign, the issues would at least have the merit of clarity. Bonds yields would soar and the currency would weaken, effects which might very well be enough, in themselves, to deter the new government from pushing ahead with its plans.

As a member of the EA, however, the stresses shift from the bond and FX markets to the arena of politics. It has hard to see how the ECB and the EA authorities can possibly give ground over the apparent demands of the incoming government in Rome, not least because whatever might be conceded to Italy could prove almost impossible to deny to others such as Greece, Portugal, Ireland and Spain.

Seen, as it must be, as a test case, the likelihood has to be that, far from helping Italy to restore la dolce vita, the EA might have to take a tough line on Italians continuing to accept la vita dura represented by “austerity”.

The next move will then be up to Rome, with the new government having to decide whether to succumb to EA diktats, or ask voters to support unilateral action.

This story will run, then, and the stakes – for the Euro, as well as for Italy – could hardly be higher.

 

Please note: the latest SEEDS dataset for Italy has been placed on the resources page.