The consensus view seems to be that the eurocrisis is contained when the European Central Bank (ECB) finally assumed its lender of last resort role arguing it would do "all it takes" to save the euro. Bond markets calmed and the crisis seemed to have been precluded.
However, underneath, things are deteriorating, not improving. Italian debt is crossing 130% of GDP. That's still not as high as Greece (170%) or Japan (220%), but we really fear it is reaching a point of no return. Continuation simply doesn't seem possible for very much longer, here is Econbrowser:
Greece's debt load of 170% of GDP and interest rate in excess of 8% means that its taxpayers must surrender 14% of the country's total income every year just to make interest payments on the debt. Portugal needs to sacrifice 8% every year. Neither is going to happen; further defaults seem unavoidable.
That's Greece and Portugal. One might argue that Italy's budget deficit (3% of GDP) is modest. In fact, if one detracts the interest payments Italy already enjoys a so called primary budget surplus. But despite these seemingly benign data, Italy's public finances are anything but stable.
The point is Italy pays over 4% interest rates and a public debt/GDP ratio of 130%. That is, tax payers have to pay debt holders (mostly domestic banks) over 5% of GDP annually. The problem is that Italy's public finances have not stabilized, due to the fact that nominal GDP is falling, the consequence of negative growth and zero inflation.
Here is Evans-Pritchard, pointing out the dangers of a falling nominal GDP, the result of negative growth and/or falling prices:
Falling nominal GDP means the debt burden is rising on a shrinking base. The "denominator effect" is deadly when the public/private debt stock is high: 276% in Italy, 300% in Greece, 330% in Spain and 389% in Portugal. It is why Italy's public debt has jumped from 119% to 133% GDP in just over two years despite draconian austerity and a primary budget surplus.
With the debt exceeding GDP and the nominal interest rate on Italian debt greatly exceeding the nominal growth rate of GDP, it's obvious the debt will keep on rising. Roughly, the level of debt to GDP which is stable is determined by the ratio of the deficit (D) and nominal growth (G), that is:
Stable debt/GDP = d/g
That is, a 3% deficit and a 1% growth rate will stabilize debt at 300% of GDP! It's obvious from the simple equation what negative growth does for debt dynamics. It's paramount that Italy escapes the negative growth rate. What's much less obvious is how to escape this slide towards a point of no return. There is no shortage of bad developments and lack of means to tackle them:
- The Italian economy has been in the slow growth lane for two decades
- Italy can't issue its own currency, control its own interest rates or monetary conditions, due to the eurozone membership
- The public debt/GDP ratio is careering dangerously upwards, as a result of low growth and low inflation compounded by austerity and the dreaded 'denominator effect'
- Italy is stuck in a catch-22 situation, trying to deflate to gain lost competitiveness worsens growth, risks deflation and worsens the public debt/GDP ratio, but it has no means to reflate, and that would worsen competitiveness.
- Lender of last resort support from the ECB can't be taken for granted.
Historically, countries have been using a combination of economic growth and mild inflation to 'reflate' out of public debt ratios in the order of Italy's. this is how the British economy survived an even higher public debt/GDP ratio after the Napoleonic wars, and then again after WWI. It's also how the US dealt with the high debt after WWII.
But Italy is already stuck in a low growth, low inflation equilibrium. Due to its membership of the euro, Italy can't devalue, it can't reflate, it can't lower interest rates, it's basically a sitting duck. The only two policy options it does have are:
- Structural reforms
Austerity, trying to reduce the public sector deficit by means of spending cuts and/or tax hikes under these circumstances is a bit like chasing its own tail. The effects of tax hikes and/or public spending cuts on growth and inflation could very well overwhelm the reduction in the deficit, making it a self-defeating strategy.
Policy makers hope to get the budget deficit to a level where it stabilizes the public debt/GDP level, but when austerity reduces nominal GDP, the policy can easily become self-defeating. This is the dreaded denominator effect mentioned by Pritchard above, where the denominator (nominal GDP) is sinking faster than the deficit reduction, increasing the ratio.
This seems to be happening, as the public debt/GDP ratio is rising inexorably and the deficit is still 3% of GDP. Negative growth also reduces tax receipts and automatically increases some spending so the deficit tends to rise as a percentage of GDP when growth is negative.
Structural reforms would help longer-term to get some dynamic back in the economy, but these are really no miracle cure, in fact, they could very well reduce growth further in the short term. And given Italy's precarious politics, taking on entrenched interest necessary for structural reforms is very difficult, especially when so much political capital has already been wasted on austerity for which the voters don't see any return.
Italy doesn't seem to have the instruments to halt, let alone reverse the rise in its public debt/GDP ratio, and this is largely the consequence of being a member of the eurozone. To understand that, it's useful to compare it with a country which has an even bigger public debt/GDP ratio, Japan.
Italy is, in some respects, like Japan. Just like Japan, Italy has fairly low household debt and considerable household savings and wealth. Japan's public finances are in an even worse state than the Italian ones, and Japan suffered from decades of deflation to boot.
Japan suffered from similarly low growth and (especially) falling prices inexorably rising the public debt/GDP ratio. Unlike Italy, Japan has refused to embark on the austerity route to get the deficit under control, and the Japanese deficit is significantly higher.
On the other hand, Japan let deflation set in, the proper response to that is massive monetary force, and this is exactly what has been happening under the first wave of Abeconomics. For now, it seems to be working. Prices (both goods and services, as well as asset prices) are rising, the yen is falling, and growth was strong this year.
It's a little too early to claim victory. Rising prices mean falling real wages, and Japanese authorities are now pleading with companies to increase wages to keep up with prices. Japan also has to negotiate its way around a sales tax increase planned for April, and inflation could quite easily overshoot.
In many ways, Japan's situation is more complex. Japan has to negotiate a tricky way out of deflation and its public finances are in a considerably worse situation compared to those of Italy. But Japan does have a few crucial advantages, it has many more policy levers to pull.
Japan does have its own currency, which it can devalue to increase growth and prices. Japan is the master of its own monetary conditions, which it is using to get out of deflation. Italy finds itself in a policy straitjacket that Japan simply doesn't have (although it suffered from a 'mental' straitjacket for two decades, but that seems to have been cast aside by Abeconomics).
See for instance what the IMF recently wrote:
Italy's economy is showing signs of stabilizing but continues to face strong headwinds from tight credit conditions.
And there is simply nothing it can do about those credit conditions.
Public debt isn't its only problem, it has to gain lost competitiveness as well, and in order to do that, it has to produce sustained lower inflation compared to the inflation in its main trading partners, especially some of the successful exporters in the north, like Germany.
So, in summary, what needs to happen to avert a crisis
- Italy needs to restore its competitiveness but it can't devalue, and since German and euro zone inflation is already so low, it's basically forced to let wages and prices fall to gain any of the lost competitiveness.
- Italy needs to boost growth but it has been stuck in slow growth for a long time already, and apart from structural reforms, it can't use any policy levers (monetary, fiscal stimulus, devaluation) to kick start growth.
- Italy needs to boost prices to slowly inflate the public debt to more manageable proportions, but higher prices will worsen competitiveness and Italy has no means to achieve them anyway.
Something's got to give
Italy's public finances are not as worse as Japan's, and deflation has not yet set in (although it's close). That is, if only Italy had its own policy levers to pull, its situation could be managed.
So we reach a disturbing conclusion. Something's got to give. Bar some miracle recovery, or reflationary policies in the rest of the eurozone boosting growth and giving Italy space (in terms of creating inflationary differentials) to recover competitiveness, Italy's public debt/GDP ratio will keep on worsening.
In the 1930s, many countries faced a similar situation under the gold standard, which robbed most of them of the policy levers to get out of the depression. According to a paper by Barry Eichengreen, the countries that left the gold standard the first were also the first to recover.
Getting out of the euro is significantly more tricky, to put it mildly. Perhaps the least disruptive way would be for Germany (and a few fellow states like the Netherlands, Finland, Austria, and perhaps Belgium) to leave and introduce a neuro, which would promptly revalue.
This would have the twin advantages that debt contracts in the periphery wouldn't have to be rewritten and these countries would enjoy their much needed devaluation overnight, instead of the drawn out deflationary process of 'internal devaluation.'
But is this likely? Not for now, we don't think so. Germany is doing quite well from the euro still. So we're likely to be stuck in the long grinding, slowly but steadily worsening public finance situation in Italy.
What could trigger a crisis
The question becomes, at what level will investors start to bail from Italian (and other peripheral) bonds? That's difficult to say, but the longer they wait, the bigger the disruption will be. No lack of candidates:
- Economic shock or disappointing economic figures
- War at the ECB leading to paralysis and markets doubting the lender of last resort
- Political upheaval
- Spill-over from a crisis in another peripheral eurozone member. We're spoiled for choice (Portugal, Greece, Spain, etc.)
Luckily, the economic outlook for 2014 seems rather benign. Growth in the US is likely to pick up, but there is always the possibility of another shock somewhere. And the simple fact is that the eurozone is one shock away from plunging into a deflationary trap.
Italy is mostly a spectator to its own slow grinding economic disaster, and it risks falling into Japanese style deflation:
Mr Perkins said Italy and Spain face a 50% to 60% risk of succumbing under the International Monetary Fund's "Risk of Deflation Index", with France at 30%. [The Telegraph]
The same article also shows that:
Germany currently needs an interest rate of 5.1% under the so-called Taylor Rule to avoid overheating as unemployment hovers at 20-year lows and the housing market booms in Berlin, Munich and other key cities. France needs a rate of 0.15%, Italy -1.5%, Ireland -3.95% and Greece -20.25%.
Needless to say, negative rates are rather difficult to achieve. Apart from that, note the wildly different interest rate requirements, once again, the one size fits nobody ECB rates are too loose in some countries and way too tight for others.
Growth is already negative and prices are already close to falling in Italy and a good many other European countries. Should this trend continue, let alone accelerate, a crisis is simply a matter of time. Add to this the sheer inexorable rise of the euro (against the dollar and especially against the yen) eating away competitiveness and putting further deflationary pressures on the eurozone, and it's clear things can't continue like this.
Here is what the OECD thinks of the policies pursued:
The eurozone's strategy of making an attempt to push down wage costs throughout Southern Europe by way of deflation is top to a financial debt entice and is eventually unworkable, the Organisation for Financial Co-procedure and Development has warned... Pier Carlo Padoan, the OECD's chief economist, stated the present plan is pushing a string of countries into deflation, and for that reason onto a much reduced growth path for nominal GDP. This switch is actively playing havoc with debt dynamics.
Deflation can relatively easily be prevented with decisive monetary action, but this is not something we can count on with respect to the ECB. Early next year we have the German Constitutional Court ruling on the legality of the ECB emergency measures. We know that the last, mildly surprising, rate cut was met with heavy opposition from the German members in the ECB council, and many German establishment figures and newspapers. Here is the Telegraph:
In April, German Chancellor Angela Merkel said the country's economy, which has consistently outperformed its eurozone peers since the financial crisis, was ready for a rate rise even though the rest of the single currency bloc needed looser monetary policy. However, Mr Draghi, and Italian, said German anxiety was misplaced. In an interview with German daily Der Spiegel, he said: "Each time it was said, for goodness' sake, this Italian is ruining Germany. There was this perverse angst that things were turning bad, but the opposite has happened: inflation is low and uncertainty reduced."
If things keep on deteriorating in the periphery, this could easily spill over into open conflict. Starkly different economic conditions are reinforced by starkly different economic philosophies pulling the ECB into opposing directions, the end result could very well be a policy paralysis in which all the burden of adjustment of the imbalances falls onto the periphery and monetary conditions are set too tight for them, which could easily let them slide into deflation.
Any monetary blitz from the ECB à la BoJ (or Fed, or BoE) isn't likely, and neither is any reflation in the north to help the periphery out of their competitiveness catch 22 and create some demand for their exports in the process. That burden of adjustment remains firmly on them.
Interest rates and lenders of last resort
From the simple formula we used in the first part of this article it will be clear why we haven't experienced a dramatic crisis yet. Even a mild pickup in growth, inflation, or both would help the debt dynamics greatly. If Italy could return to just 3% (nominal) growth, debt would be stabilized at 100% of GDP (probably less as the positive growth would shrink the deficit further).
But there is a wildcard here in the form of interest rates, and once again, being a member of the eurozone turns out to be a problem. We see that countries issue their own currency and have their debt denominated in it, can't really go bankrupt. Japan with it's much higher public debt enjoys much lower interest rates (less than 1% compared to over 4% for Italy on 10-year paper, even before Japan embarked on massive QE) compared to Italy as a result.
We also experience how Italian interest rates (and those on other eurozone peripheral debt) threatened to career off the charts when there was significant doubt about the lender of last resort role of the ECB. There exists an excellent paper by Paul de Grauwe, which should be required reading on this topic.
Since September 2012 the ECB has the Outright Monetary Transactions (OTM) instrument. The mere announcement was enough to calm bond-markets. However, this OTM has never been used, and it's supposed to be conditional to combat any moral hazard problem.
In exchange for the ECB buying potentially unlimited quantities of bonds, countries have to sign up to a strict diet of policy measures and it's entirely possible to foresee a situation in which the political support for that is simply not present in the country hit by a run on its bonds. German support for the OMT isn't exactly iron cast either. They seem to think (wrongly) that the ECB can go bankrupt, or that there is considerable risk for runaway inflation.
The conditionalities might be too much for the country receiving OTM support, whilst unlimited bond buying isn't something that one can find in a German dictionary. We always argued that the lender of last resort function had to be announced (which the ECB did, with the OTM), this would provide magic, a window of opportunity to address the underlying issues.
But if the underlying issues are simply deteriorating further then sooner or later the OMT might be called into action. We wouldn't really want to bet on any outcome. Perhaps the most favorable outcome of that would be that the Germans would balk at unlimited bond buying, and choose to leave the euro altogether, finally liberating the periphery from the euro straitjacket that is suffocating all economic life out of them.
But such event wouldn't exactly go unnoticed in world financial markets.
With a 3% deficit, stabilizing Italy's large debt burden isn't actually such a tall order. However, doing so under the euro regime, under which most policy levers are not accessible, it becomes quite a different proposition. Having to improve competitiveness at the same time complicates matters further, especially when these fellow eurozone members have very low inflation rates themselves and are unwilling to reflate.
This whole policy regime locks Italy in a low growth, low inflation equilibrium that makes stabilizing, let alone reducing, its large public debt burden very difficult. While it might seem that, given the implicit lender of last resort guarantee by the ECB, the prospects for an immediate crisis are low, but the ECB cannot be taken for granted, and any even mildly negative economic shock could well throw Italy, and with it a large part of the eurozone into Japanese style deflation which would wreck further havoc on public finances.
The euro hasn't brought prosperity in the periphery such as Italy. It brought these countries either too lax monetary conditions and capital inflows before the crisis, leading to an accumulation of inflationary differentials and a steady loss of competitiveness, and too tight monetary conditions and a policy straitjacket after the crisis.