#127: Quantum of risk, part three


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.



183 thoughts on “#127: Quantum of risk, part three

  1. George Soros

    I suggest that people should take a fresh look at De Sica’s (a real life aristocrat) movie The Leopard. Burt Lancaster, playing a Sicilian aristocrat during the turmoil that surrounded Garibaldi and the unification of Italy, tells his nephew (Alain Delon) that ‘things have to change so that nothing changes’.

    If the EU embarks an an accelerated program of fiscal expansion (i.e., more debt), then the billions will only owe more money to the 1 percent (much of it presumably in the form of government debt). But there will be no probability that the 1 percent will be taxed to cover the payment. If that was the program, then it could be resolved by simply mandating that the 1 percent invest more in real productivity in the Eurozone.

    I’m not claiming that Soros is cynically pulling strings…I believe he and the rest of the 1 percent believe that they are doing God’s Work (Lloyd Blankfein of Goldman Sachs). They cannot imagine creating a few trillion dollars of debt out of thin air and then turning it over to a bunch of unwashed Italians and Spaniards to spend as they wish.

    In order to gain some understanding of what is going on, I think it is helpful to review Capra and Luisi’s The Systems View of Life. In section 13.3.4 they define a social organization (from a family to the brotherhood of man…and perhaps beyond) in terms of ‘a common context of meaning’. Which implies that the 1 percent MUST keep a majority of the 99 percent feeling that they are, somehow, part of the club.

    Rob Hopkins has an interesting interview with a psychoanalyst today:


    Sally Weintraub had been to Cophenhagen for what was supposed to be a serious meeting on climate change. She concluded that the Powers That Be ‘didn’t care whether we survived or not’. She think the attitude changed in Paris, but is now changing back again. A more cynical take would be that Copenhagen revealed the true positions of the 1 percent, but they realized, like Burt Lancaster, that ‘things have to change so that nothing changes’. At any rate, Weintraub now does not feel that she is in the same club in terms of climate change as those making the policies. Albert Bates, who writes about climate matters frequently, has said that he watched in Copenhagen as Hillary Clinton and Barack Obama calmly torpedoed any chance for real change. Yet Hillary and Barack came out of Copenhagen with their images largely untarnished. How does that happen. Which leads us into the hall of mirrors called political spin.

    To touch on a minor point. A dose of a psychedelic substance would bring to consciousness the conviction that one is NOT part of the same club as the 1 percent. Absent psychedelics, we will continue with a political spin program for some undetermined time into the future.

    Consider the problem that Brussels has. They have to change, so that nothing changes. So they dare not admit that Russia, under Putin, has adopted the sanest policies in Europe. Therefore, Dr. Morgan’s work must be ignored or ridiculed.

    Don Stewart

    • As for ‘feeling part of the club’, Jared Diamond says that the reason why strong young tribesmen don’t knock weaker old men on the head – to take the young wives and best cuts of pork which are the privilege of the old – is that they all know that in due course – if they survive – they too will get to enjoy the 14 yr olds and best dinners, according to tradition……

      In the meantime of course, they snatch what pleasures they can when the old men are dozing. All the sweeter for being illicit, no doubt.

      Perhaps the 1% would do well to reflect on this?

      We could call it the ‘P&P Principle’.

  2. Charles Smith: Buffers and Sudden Collapse


    Not being a European, I, of course, have direct access to what the bureaucrats in Brussels are thinking. My guess is that they sense that the ‘buffers’ which hold the EU together have worn thin. The Target 2 balances are evidence. Charles point that once the buffers are exhausted, it doesn’t take much to trigger a total collapse from which recovery is impossible, is perhaps a timely warning.

    It may be that the people in Brussels sense, at some level, the peril. They seem to have adopted Chariman Mao’s philosophy of ‘the barrel of the gun’. I don’t see how their plan can succeed. But maybe I miss some strong emotional ties to the notion of ‘Europe’. I remember Kieslowski’s movie Blue, where Juliette Binoche’s husband had written a Symphony for Europe which sounded pompous to me but was supposed to be very inspiring. Perhaps some of that optimism is still around? Or maybe the 1 percent are calling in all of their chips?

    Don Stewart

    • Thank God, nature will take over when we screw up. When truth knocks at our doors, we will all recognize her.

    • Germans do seem to be a bit sentimental about the idea of Europe.

      Italians and French are far too cynical to be taken in.

      Many Spaniards look to European institutions as a refuge from the corruption and authoritarianism of the conservative forces in the country – however, the response to the Catalan issue opened their eyes somewhat.

      The insistence on absolute freedom of movement and telling people they have to put up with mass migration is causing immense damage to the European ideal: people rightly ask, ‘What is Europe if it is going to consist of Africans and Asians?’

      And the Left see Europe as having been captured by Capital and the 1%, rather than being a ‘Europe of the People’ or some such nonsense.

      However, being a Euro MP is still one of the best gigs going.

    • @xabier

      Your view that mass migration and free movement leads to:”What is Europe if it is going to consist of Africans and Asians?” may be a good way to speed up the EU project. Add in multiculturalism and can you think of a better way to obliterate the nation state? It may not be deliberate but it’s certainly effective.

  3. Our host might recall the jewellers in Trinity Street, Cambridge, been there forever? It has just, to my astonishment, been repossessed for non-payment of rent by the College, something I have never seen in that street, the best commercial bet in town! With all the other boarded-up premises in the city centre it is looking rather ominous…….

    Talking with shop owners, there is also a feeling that high parking charges – attempting to drive people on to ‘green’ buses (very crowded and inconvenient) – are killing retail here. It is now about £40 to park for a Saturday of shopping and eating…..

    Should I be building an Anderson shelter? When do the warning klaxons sound? 🙂

    • I do just about remember that shop. The last time I went to Cambridge I couldn’t find anywhere to park, even out by my old College’s sports grounds, so I gave up. In more recent times I have always used the “park and ride” to go into Norwich. I often find myself in places where, whilst there is hardly anyone about, there is still nowhere to park!

      I suspect that the world has about twice as many cars as it can cope with!

  4. I suggest a little article buried in The Guardian is relevant to our predicament, relating to a skeleton recently dug up in Pompeii.

    The title says it all (and the accompanying image):

    ‘First the eruption. Then a big rock fell on him’.

    We are in the midst of an eruption rumbling sine 2008: who will be the first to get the Big Rock?

  5. Forget about the World cup I think economic events in Europe (and the World) are going to be far more exciting.

    However in relation to the World cup I wonder if Putin is going to temporarily put a hold on murdering anyone his regime doesn’t like once the first game has kicked off – another journalist was shot yesterday (Arkady Babchenko)

    • Good point.

      I am wondering if the US might also call a halt to murdering and maiming innocent people around the world for the duration of the world cup.

      Then we could all sing Koombaya

    • Murders will only stop when the Salvation army is elected to form a World Government. Donations maybe made compulsory though.

    • Given British anger – and whether justified or not isn’t the issue – it seems odd that England are still going to the World Cup in Russia.

      I have to say that this is easier for me to discuss – Wales didn’t qualify……

    • Yes I remember that one – but also love Jeremy Paxman trying to get a straight answer out of Michael Howard (with all due respect).

      I think Gavin was a bit reckless with regards to the comments he made against Russia – I fear his name has gone into the book.

  6. Markets look calm today, though no “dead cat bounce” yet – exactly as one would expect (slide, pause, slump).

    Meanwhile, with both Canada and ‘a brief guide to GFC II’ nearly complete, I’m minded to publish GFC II first.

    • Funny you should post that as I’d just finished doing a quick calculation of a spreadsheet regarding 7% rises over the next 20 years ( 7% is pure guesswork) and working on the assumption that real wages will not increase.

      Not sustainable for many households

    • The 7% is nominal, so I think it would be necessary to assume some increases in nominal incomes?

      Bigger increases would be in order if (a) energy prices rise, or (b) GBP weakens.

      The fact of a rising price of energy is consistent with the trend in ECoE, and ties in with other energy-intensive components of household expenses. My ECoE number for the UK was 8.6% last year, and is 9.0% for 2018 – a big rate of increase of 5%.

    • So just pop those figures into a spreadsheet plus the average household take home wage and you’ll come up with an alarming scenario within the next decade although it’s pretty bad now. (I hadn’t factored in a rate of increase which of course makes it even more frightening)

      Basically poorer families will not be able to afford to heat their homes fullstop.

    • Turning off the heating and going cold in winter is now a majority sport in New Zealand.

      Just over half of New Zealand households cut back on heating their homes in winter due to the cost, a survey of nearly 1300 householders by Credit Simple found.

      In Auckland 55 per cent of households go cold in a bid to save in the power bills. In Wellington, it’s 52 per cent. In Canterbury, it’s 50 per cent.

      So pricey is our electricity, that Kiwi households pay more for it than Norwegians, whose average wages are a third higher than ours.


      “Rising petrol prices could be an obvious one that is currently squeezing household budgets.”


      This will be the same .. the world over….

    • Thomas the Daily Mail is a right wing journal who of course would deny that things are getting worse. It’s main ‘trick’ is the overuse of adjectives to get you to click on what are really mundane and badly written stories.

      Regarding NZ I didn’t know things were so bad out there.

      I think people going out for a Sunday drive / pleasure drive is going to become a thing of the past with only essential drives taking place. I think manufacturers are going to regret building large thirsty cars again for the short period when petrol became cheap.

    • People are going to buy less because they will have less cash to spend due to high energy prices… which will lead to a deflationary death spiral at some point

      As Tim points out — credit filled the hole when oil went to 147 in 2007…. now everyone is up to their ears in debt… so the only option will be to cut back.

    • Yes indeed. Back in the prosperous 1990’s and early 2000’s everyone – at least in the finance sector – expected large annual bonuses and above inflation pay rises.

      It was the norm with ever increasing standards of living. I remember a headline in the Independent newspaper of 1999 proclaiming there was simply too much oil.

      Another commentator said – ‘Go forth and multiply – there’s lashings of the stuff (oil)’.

      We certainly need to concentrate – where possible – on making do. I love hiking more than anything else

    • Tragically, yes. If you look at research on this issue by the Joseph Rowntree Foundation, you’ll see that this is already happening, with a sharp rise in the numbers of millions already living in hardship.

    • Surely someone in the Government has done this simple analysis? Having said that as they’re all firm believers in real wage/economic growth then it won’t be seen as an issue.

      Yet all the evidence is here which tells the opposite.

    • These are horrifying numbers.

      I have noticed a huge jump in fuel costs here in NZ…. subsidized diesel is now NZD1.73 per litre in Queenstown… petrol is pushing 2.50….

      I am cringing each time I watch the ticker hit the $100 mark on a fill up….

  7. I take research from the left wing Joseph Rowntree foundation with a bag of salt. They have a grievance stirring agenda .
    Increasing numbers of people are becoming obese making themselves a burden upon the health service. More children are being sent to school unable to dress themselves or use the toilet. I don’t see a lack of prosperity – I see a lack of personal responsibility brought about by too much government and too much welfare spending. Why is the government providing a state child minding service for parents? .
    GFC II won’t be entirely a bad thing…bad money can do more harm than good bribing the voters has some very unpleasant side effects!

  8. Tim despite everything are we still better off that we were in the 1970’s? Is poverty more rife?

    • We are still materially more prosperous than we were in the 1970s. Also, poverty is to a certain extent (but not entirely) a relative concept.

      More broadly, though, are we happier now than we were then? I’m less sure about that.

    • I can only repeat the old line ‘What you never had – you never miss’

      From a previous post you’ll know that I spent a few years in a bedsit trying to save for a deposit for my first property (yes it was possible back in the early 1980’s)

      I started with few possessions but eventually worked my way up to having a colour TV – a fridge – video recorder (wow) and even a Sinclair Spectrum.

      But I was pretty happy despite only being able to afford one ultracheap holiday a year.

      One thing we could take note of is perhaps our housing stock had deteriorated since then due to lack of maintenance – there are certainly plenty of horror stories around of families living in damp cold property.

    • One thing I should add is that I did have a career path back then so I knew my standard of living would improve. Nowadays many young people have no such future which must be very depressing.

      So I would say young people maybe less happy.

    • I went through similar experiences, though starting a career in the City (this was the early 80s) did help. I did the bedsit thing, too, in my case in Scotland, with windows that didn’t shut properly, and minimal heating, no joke at all when the north-east winds blow.

    • It would have been cold in Scotland but at least you could have left you butter and milk on the window ledge if – like me – you were initially fridgeless.

      I hope you didn’t have an electricity meter which used to devour 50 pence pieces…you probably did.

      I do feel for young people especially those working / stuck in the Gig economy. An uncertain future and very little chance of getting on the property ladder.

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