- Overall money flows are weak and decelerating, unemployment is high, the scene is set for radical political solutions in the forthcoming election.
- The current account is stronger and adding income to the private sector, but this income has been used to repay debt and so does not add to aggregate demand.
- The government has drastically cut spending in 2017 and looks to do the same in 2018 unless a new party can be elected to reverse this trend.
- Private credit creation by commercial banks is running in reverse with more loans repaid and written off than new ones created.
The purpose of this report is to look at macro money flows in Italy and assess the impact on investment markets.
Italy is having a national election on March 4, 2018, and the outcome will be interesting to see. How do 11% general unemployment, 31.5% youth unemployment, and a shrinking national income affect election outcomes? Could an upstart fringe party get elected and implement the much needed radical change?
I last looked at Italy in this article: Italy ETFs Are A Buy. I have written this update in response to the lead up to the elections. This report was produced using a balance of national accounts assessment of Italy. The Italian situation is very similar to Portugal that I looked at in this article.
One can summarize the national accounts in the following formula:
GDP = Private Sector Spending [P] + Government Sector Spending [G] + External Sector Spending [X]
See the methodology section below for more details on this formula.
Each sector will be examined in turn, starting with the private sector.
The private sector is where the stock market is and we as investors want the stock market to go up. The stock market can only go up if the flows into it are positive. The private sector derives income from three sources:
Credit creation from banks - More loans created than repaid.
Externally from overseas commerce - More exported than imported.
Government spending - More spent than taxed out.
In an ideal scenario, the private sector would receive large and growing income flows from all three sources, and at the very least, the overall impact should be a positive flow overall even if one or two of the three flows are negative. The stock market in the private sector, as well as all other private financial assets, should rise if the overall income flow into the private sector is positive.
Certainly, the stock market would be unlikely to rise if the income flows were negative. One has the best chance of earning a positive return in a private sector that is growing rather than shrinking, and this should be a macro investing consideration for any investor.
The table below shows the level of private credit creation entering the private sector through commercial banks in 2017.
Bank credit creation fell in 2017 as people paid back their loans or they were written off. Falling credit creation and general private debt deleveraging have been going on since the peak in 2012 as the longer-term chart below shows:
The interplay between bank lending rates and the amount of credit credited is interesting. In 2010 the banks lowered their rates and lending grew again. In late 2012, rates were increased and credit growth stopped and reversed. Despite steadily falling lending rates since then, credit growth has not resumed.
One could renegotiate one's loan and halve the debt service burden.
The chart below shows the overall stock of money, and it rose this year by 80B euros:
The flow of private credit adds or takes away from the stock of private debt in the economy, and this stock is shown in the chart below:
One can see from the chart above that private debt levels are falling steadily with no sign of slowing down and bottoming despite a lowering of the lending rate by commercial banks.
The stock of debt is 120% of GDP. The impact of the debt service on this stock of debt can be modeled over a range of interest rates as shown in the table below:
The central bank rate is 0%, and the interbank rate is -0.3%, so if commercial lending rates are 3.5%, the debt servicing cost is about $70B, or 4% of GDP. If rates were "normalized," as the central bankers, politicians and popular press keep parroting, at say 3%, the debt service load would be $140B or about 8% of GDP. 8% of GDP spent on bank interest to banks instead of real goods and services.
Professor Steve Keen has found that a private debt level of 150% of GDP tends to be a natural barrier and that economies that reach this level tend not to become more indebted. Italy has not reached this level but is still deleveraging rather than growing into this natural carrying capacity and so other factors must apply in addition to the 150% rule of thumb.
In theory, private credit creation could expand into the remaining 30% of carrying capacity. Higher interest rates on the debt load influence the ability of the economy to carry it, the debt carrying capacity moves inversely with the interest rate (price of money).
The Italian private sector must consider the price of money already too high and is repaying its loans, and some bad loans also being written down. This is the unprinting of currency as it removes it from the stock of money in the economy. The Italians unprinted -$73B in 2017 or 4% of GDP.
The external sector captures trade and commerce with other countries and is shown in the current account. The current account is exports less imports, and also includes capital flows in and out of the country from financial transactions and investments. A positive overall result is best.
The chart below shows the current account balance. The 2017 result is positive and much stronger than 2016 at over 5% of GDP or $90B income added to the economy.
This current account income flow adds to the stock of foreign reserves held. The stock of foreign exchange reserves is shown in the chart below:
Reserves were flat through 2016 and have fallen in 2017 by 5B euros. Earlier in 2017, they were over 10B euros higher than the end of the year.
The government budget is shown in the chart below:
The result for 2017 is at hand and is 1.9% of GDP or financial input of about $35B.
The result is a big drop from 2016 where about $48B was added to the economy by the government. This is a 27% reduction.
Government spending adds to the stock of government debt. Italy is not a monetary currency sovereign. Italy is a user of the euro which it borrows at interest from the ECB and other bondholders. The chart below shows the stock of government debt owed to the ECB at interest:
In 2017 the stock of debt remained mostly the same, though was as high as 2,300B euros in July but was paid down by 42B euros.
The Italian 10-year bond currently trades for just over 1.92%. This means that the stream of income flowing to the ECB and other bondholders is $45B per year or 2.5% of GDP.
One can see where the $90B current account surplus went to. It went on interest and debt payment on government debt, and that is why the stock of foreign reserves fell instead of rising in the same period.
In a monetarily sovereign country like America, this income stream would flow to private sector holders of government Treasury securities and add to the stock of money. The benefit of this state money is that it is debt-free; it has no liability attached to it in the way that bank-created credit money has.
In the case of a member of the EU, the income stream flows back to the ECB. The ECB is the bank for the EU. The EU is a sovereign federal entity and the issuer of the euro. The issuer of the currency does not need income as it is the source of the unit of account; it creates money when it marks bank account balances up and destroys money when it marks them down. This means that when the bond interest and principal repayment returns to the currency issuer, it ceases to exist. The nearest analogy is returning light to the sun or seawater back to the ocean.
This is a key reason why the euro is rising in value at present and is discussed in this article in more detail. Only sentiment can knock the euro down in value now as the fundamentals of supply and demand are pushing its value up and retracements in price can be bought.
An upset Italian election and a government that wanted to introduce its own currency again would be a good reason for the euro to fall in value despite a rising fundamental bias and would make a good trade to buy on the dips.
Sectoral Analysis Methodology
Professor Wynne Godley developed the stock flow consistent sector flow framework of analysis.
Each nation state is comprised of three essential components:
The private sector
The government sector
The external sector
The private sector comprises the people, business and community, and most importantly, the stock market. For the stock market to move upwards, this sector needs to be growing. This sector by itself is an engine for growth and innovation; however, it needs income from one or both of the other two sectors to grow.
The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained. For a sovereign government with a freely floating exchange rate, any financial constraint such as matching bond issuance with deficits is a self-imposed restriction. A debt ceiling is also a self-imposed restriction, as is a fiscal brake.
Note that Italy is not a monetary currency sovereign and so does not enjoy the sovereign privilege described above.
The external sector is trade and commerce with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.
For the stock market in the private sector to prosper and keep moving upwards, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is always growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
The following formula can express this relationship:
GDP = Private Sector + Government Sector + External Sector
These are accounting entities and correct by definition.
For the best investing outcome, one looks for countries with stock markets located in private sectors that are receiving positive income flows overall. Top marks come where private credit creation, the government sector, and external sector are in plus and trending upwards.
Conclusion, Recommendation, and Summary
When we take our inputs and place them in our formula, we can calculate the following sectoral flow result based on a percentage of GDP.
Private Sector Credit Creation
(Source: Trading Economics and Author calculations based on same)
*Estimate until actual figures are reported.
#Forecast based on present trends and plans.
This report has shown that the fiscal flows in Italy are weak and declining.
The private sector is decreasing its stock of private debt, and this drains money out the private sector economy and decreases GDP and the money supply.
The current account is adding money back into the private sector as is the government sector. The current account surplus earned by business was obtained as a result of the process of internal devaluation, whereby unemployment and wage cuts are used to lower business production costs and thus make exports more competitive.
The unemployment created by austerity internal devaluation politics then came back as a direct cost to the government in the form of unemployment benefit payments of much more than the $90B income earned overseas - a loss overall across the sectors, but a win for owners of export businesses in Italy.
The government managed to contribute less to the economy in 2017 than 2016. Cuts to education, healthcare, and infrastructure spending for the public purpose would have achieved this saving.
The current account surplus was then paid to the ECB to lower government debt and in so doing was deleted from the money supply. The stock of foreign reserves earned that year fell by approximately the sum of the interest and debt repayment.
One sees here how one sector of the business class profits at the expense of the rest of the population and government.
On an even grander scale, one sees how a whole nation suffers by being part of a private banking union known as the EU and its bank the ECB. Borrowing money at interest that a sovereign nation could have created for itself at no interest.
What is not included in the direct costs are the losses regarding poorer health, education and infrastructure standards from the government cutbacks. This is a silent, hidden cost that builds over time in the same way as environmental pollution.
Going forward, one can expect the private sector to continue to lower debt levels as the trend shows no sign of letting up. Even halving the lending rate has not stopped the decline in credit growth.
The current account is likely to worsen or stay the same given that the euro is rising in value and thus makes exports less price competitive. Italy is a microcosm of why the euro is rising. It is rising because it is in decreasing supply due to private and public sector debt repayment.
If a lower exchange rate is desired, this can be achieved by issuing more currency to increase the supply. If private banks are not doing this through lending, then only the currency issuer, in this case the EU/ECB, can do this. Fiscal spending would solve the problem but would also add to private sector incomes and then lift the demand for imports which again would put pressure on the currency to rise. More than likely private sector recipients of government fiscal spending would use it to repay their private debt which again leads to the money being unprinted but relieves weak private sector balance sheets.
The Italian government is restricted voluntarily in what it can do given that it is a member of the EU and has agreed to operate within the Fiscal Compact agreement whereby government debt is limited to not more than 60% of GDP (now 131.5%) and government deficits to not more than 3%.
When the number of unemployed rises and government expenditure rises to pay unemployment benefits, the government attempts to stay within budget by cutting spending on health, education, and infrastructure. This is a destructive downward spiral common to many nations in the Eurozone and will have adverse long-term effects.
What can one expect from investment markets under such circumstances?
The chart below shows how the stock market has traded using iShares MSCI Italy Capped ETF (EWI) as a proxy:
Flat to falling stock markets is the general rule, and expectation with fiscal flows so weak and in decline.
The market for real estate is also weak as the chart below shows:
Ten years of falling to flat prices since the GFC boom-bust and a 20% loss for those that bought at the top of the market in 2012.
Let us hope that the election will put a party in power that makes regaining monetary currency sovereignty its goal as this would cure most of Italy's problems if appropriately managed for the public purpose. At present, Italy is managed for the benefit of export business owners, the ECB, and bondholders but not for the benefit of the general population. This can be changed at the ballot box.
If one wished to invest in Italy, the following ETFs could be used:
This article was written by
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