The Italian Job

by: Kevin Wilson


The failure of Keynesian and Monetarist theories appears to have used up central bankers ammo in Europe, so they have turned in desperation to NIRP.

Some have asked, "What form will the next crisis take?" We have choices, but one is that the banking system in Europe will fail, starting with the Italians.

Italian non-performing loans (NPLs) are threatening the survival of some of the largest Italian banks, and financial sector stocks have plunged as a result.

The new EU rule, even as modified by Italian negotiators, might have a tendency to push capital flight even higher, as fear of haircuts and "bail-ins" endanger faith in the system.

It is fascinating to watch the machinations of central planners around the world who have yet to learn the lessons taught by famous economists and thinkers like Friedrich von Hayek, who wrote of the perils of central planning as far back as 1944. I am referring of course to modern central bankers and bank regulators, who generally seem to believe in what has been called "zombie economics." In other words, they believe in economic theories like monetarism or Keynesianism that were disproven or at least severely damaged by criticism decades ago. The failure of both theories as practiced by modern policymakers has not dented what can only be called their faith, at all. I believe that the intellectual paradigm these people live in is framed by both rationalistic and deterministic beliefs. Thus they seem to view our enormously complex modern economies as mere clockworks or mechanical toys, and like such mechanisms they are considered predictable, logical, and readily manipulated. However, there is little in human nature that is rational or predictable when huge populations interact on a large scale.

The Keynesians believe that recessions, especially great ones like 1929 and 2008, should be fought with massive government spending designed to replace falling consumer demand. However, the Japanese experience stands as a resounding rebuke to this theory, with the Japanese government having tried over 20 Keynesian stimulus packages in 25 years, with seemingly no lasting positive effects. Indeed they are facing recession yet again. Nor has stimulus worked well since 2008 in most other countries, with the possible exception of China. And China undertook so much mal-investment as a result of the stimulus that they will face slower growth, deflation, and a lingering credit crisis for years.

Keynesian Success?

The monetarists on the other hand believe that economic problems such as recessions are caused by sharp declines in consumer demand that are best dealt with by changes in the money supply. This belief has driven their attempts (in many countries) to fix weak economies by loosening monetary policies to unprecedented extremes. Thus we have seen Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) instituted in response to the massive financial crisis in 2008. There was justification for these extraordinary measures in the midst of the crisis, but now these measures have become ordinary, and they have not been working. Years of failure under ZIRP and QE policies around the world have recently inspired indefatigable central bankers to try the newer, and perhaps more radical idea of Negative Interest Rate Policy (NIRP).

Negative rates have prevailed in parts of Europe for almost three years, and there are now over $2 trillion of bonds in Europe with negative interest rates. Demand is not exactly cooperating though, at least so far. Loan demand growth has done ok, but NIRP has not caused higher inflation, or increased the money supply, or increased the velocity of money, according to a study published by Citi Research. Nor I would add, has NIRP prevented declining manufacturing activity in countries with NIRP in place. In spite of the muted evidence in favor of NIRP, the BOJ just announced a new NIRP program for Japan last week. Markets reacted joyously out of renewed faith that central banks have got their back - a naïve belief that is almost charming in its innocence.

The idea here seems to be that, since ZIRP and QE helped the markets but not really the economies concerned, something more had to be done. GDP growth rates have been falling worldwide, and the central planners can't just sit there and watch. The big idea: perhaps doubling down on ZIRP by moving to NIRP, and retaining the optionality of QE, would force demand (this time) to go higher as the cost of sitting on cash becomes prohibitive for those affected by NIRP. Banks will lend more, and people will spend more under this strange and anti-capitalist theory. Well, certainly, as NIRP spreads around the planet, forcing bankers (and eventually savers) in many countries to lose money even when seeking safety, something big will happen. The failure of ZIRP and QE, as evidenced by the move to the even more desperate NIRP, implies that central bankers are running out of ammo for their monetary bazookas.

With recessions spreading from Canada, Russia, Brazil and Japan to other economies around the world, and with China facing a potential credit crunch, it looks like we are running out of options and may have to actually face the music. When our next financial crisis finally arrives, what form will it likely take? Will it be like the Stay-Puft Marshmallow Man in the movie "Ghostbusters," a monstrous nightmare version of a seemingly benign (e.g., high bank leverage; or extend and pretend junk loans) long term financial practice? Or will it arrive silently, as a new and stealthy, but effective killer of the zombie banks left over from the Great Financial Crisis (e.g., NIRP)? We may have to wait a while yet to see. But there are problems arising in the banking systems of China, Italy, Spain, Greece, and a few other countries that could be significant issues.

Of special interest recently has been the growing crisis in the Italian banking system. Well-known analyst and author George Friedman has pointed out that Non-Performing Loans (NPLs) in Italian banks now amount to $216 billion, about 17% of Italian GDP. Standard government bailouts for failed banks are a problem, since Italy's debt/GDP ratio is already more than 132%. Four small Italian banks failed in September, and although they only represented 1% of Italian bank deposits, shareholders and bondholders (130,000 people in all) lost about $856 million. In Italy it is common for bank bonds to be sold to yield-starved retail investors, so these losses are not just impacting corporations. In fact, Jacob Shapiro wrote on that Italian households own about $257 billion in domestic bank debt. New European Union rules will impose future bank losses on shareholders and large depositors (via "bail-ins") before taking recourse to public money. This could have big knock-on effects on the Italian banking system and economy. The Italian insurance deposit scheme seems unlikely to be able to cover more than a fraction of any future losses, as its assets/deposit ratio is about 250:1. For comparison the US banking system insurance deposit scheme (FDIC) has a required assets/deposit ratio of 100:1, but US banks no longer have huge NPLs either.


Those potential losses may be pretty big. The venerable Monte dei Paschi di Siena bank has NPLs totaling about $49 billion, and has already been bailed out twice since 2009. Along with five other banks (including giant UniCredit), Monte dei Paschi announced on January 18th that the ECB had requested information for reviews of NPLs held by the banks. Markets have panicked in reaction, with share prices for Monte dei Paschi dropping more than 40% since the announcement. There has also been a bit of a run on the bank by depositors, although so far it appears to be minor, if the bank's CEO is to be believed. Experience suggests that they wouldn't really tell us if it wasn't minor. Italian banks in general were down 17% YTD through January 25th. According to the Macro-Man blog, the largest banks are priced no higher now than they were at the end of 2007.

Bank bonds have been trading for less than they did at the height of the banking crisis in 2011, according to Dan McCrum, who wrote about this problem recently in the Financial Times. Italian PM Matteo Renzi made a deal with the EU to cushion the blow from NPLs, but clearly the markets are not impressed so far. The deal allows banks to offload NPLs as bundled securities in exchange for buying government guarantees on the least risky tranche, according to the Irish Examiner, but market observers don't believe it will solve the problem. Indeed, the whole notion of theoretically safe tranches imbedded in extremely risky bond issues reminds me a bit of the subprime credit crisis in the US in 2008, and we know how well that episode of financial engineering turned out. For these and a variety of other reasons, Italian bond markets in general have been selling off, with spreads to German bunds now 1.69%, the widest since last August.

Now let's throw two other factors into the mix: the weak Italian economy and the impact of the ECB's 18-month old decision to institute NIRP. Italian GDP is estimated at 1.5% this year by the Italian central bank, for what it's worth. Last year GDP growth was only 0.8%, and in the 4th Quarter it was only 0.2%. The IMF, not noted for their pessimism, has called for about 1.3% GDP growth. The Bank of Italy admitted that there are significant downside risks to these growth figures, based on the global slowdown. The Italian government is seeking EU permission to run a larger deficit than the 3% they're allowed under normal conditions. But even with this rule, as analyst Mish Shedlock has pointed out, Italy has been unable to stop the growth of its huge debt pile. Youth unemployment is still 39.8% as Italy comes off a very tough triple-dip recession. There is political anger at the way the bank bail-ins went down, but the fact remains that with the new EU rules, any new bank failures could involve haircuts for bondholders and even depositors, just as they did in Cyprus and Greece. The EU's Target2 balances suggest that serious capital flight may be going on, with Italy carrying a negative $249 billion balance as of January 11th, according to Mish Shedlock, which is the worst level ever seen since the Eurozone formed.

What's really interesting about the Target2 negative balance for Italy is the fact that when depositors move their funds from Italian banks to foreign EU banks, those recipient banks place the new money at the ECB, and therefore are now receiving negative interest rates on it because the ECB has long since instituted NIRP. Then by simple math NIRP therefore guarantees a loss to these foreign banks. I love this plan! Now we can use the ECB's banking rules to spread financial contagion. The more trouble in the Italian banking system, the more potential trouble for bank solvency elsewhere in the EU as capital flight increases and profits decrease as a result of NIRP. What an amazingly well-thought-out system.

So what are the chances that the Italian banking system blows up? I have no idea of how to quantify this, but it is ominous that the EU has permitted bail-ins to include haircuts for larger depositors. This is an open invitation for bank runs and capital flight, and now there is a fact pattern telling people to expect the worst, because they have already seen what happened in Greece and Cyprus. It appears to me that by allowing larger depositors to get bilked by poorly managed banks, the EU has inadvertently opened Pandora's Box. At some point depositors in Italy will heed the advice already being given on a few financial blogs: "Get out now!"

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