Finance: Research, Policy and Anecdotes

I attended a very interesting half-day conference on What Next for Italy, organised by the Brevan Howard Centre at Imperial College with presentations and discussion by both economists and market participants as well former IMF staff Ashok Mody introducing his new book. There was quite a variety of views, which I will discuss in the following, with my own ones added (the event was under the Chatham rule).

The good news first - both market participants and some economists are rather sanguine about the current situation, especially when compared to 2011 (when rising Italian spreads caused - among other events - Mr. Draghi's famous "whatever it takes" and subsequently the OMT announcement).  There seems to be some fiscal space to at least partly implement the new government's campaign promises (maybe 1.5% of GDP), which would still leave some primary surplus left.  Italian sovereign debt seems more sustainable now than seven years ago, even after implementing these fiscally rather "damaging" promises.  Non-performing loans in the banking system have been decreasing with the secondary market in non-performing assets picking up.

Unfortunately, that is where the good news stops.  There are some obvious risks, including rising interest rates and shocks to current growth, which could turn Italian quickly again unsustainable or would require a higher primary surplus. The global trade war that has just started can provide one very obvious negative growth shock. Possible domestic shocks, related to political uncertainty are another source. There could be a major confrontation between Brussels and Rome, related to either fiscal policy, migration or some other policy field, possibly resulting in a "Syriza moment" (to the cliff and back) or a step beyond the cliff towards Italexit.  There could also be accidents, such as a wrong policy response to a major shock, e.g., in the financial markets. The "opportunities" for accidents are plenty, unfortunately!

However, this rather short-term view is overshadowed by longer-term growth constraints: decoupling again retirement age and life expectancy will put the sustainability of the pension system under threat; in addition, long-term sustainability of the pension system requires more (rather than less) inflow of migrants. But ultimately, it is the low productivity growth (related to inefficient resource allocation and credit constraints, as very nicely summarised by Martin Sandbu), which has driven low Italian growth over the past 20 years.  And while demand-side policies might not have been sufficiently used during the Eurozone crisis and sluggish recovery, I find it doubtful if a major fiscal expansion, funded either by the ECB or by mini-BOTs, issued by the Italian government as "parallel currency", can be helpful. The chance to use fiscal policy in a major way (such as in the US in 2009) seems too late and the delay in monetary expansion by the ECB (due to political constraints) is water under the bridge.

Which brings us to the long-term if not historic picture. The idea that the Euro could serve as external constraint to force the Italian economy and policy-making to modernize has obviously failed. While not as bad as in Greece, all governance indicators point to Italy having substantial gaps in the control of corruption, quality of judiciary and rule of law, and the efficiency of government. Most observers agree that Italy (for its own benefit and that of the Eurozone) should have never entered the Eurozone in the first place, even if it might be catastrophic to leave.

Where does this leave Italy - leaving the Euro (be it intentionally or by accident) would come at an enormous cost - for the whole Eurozone if not global economy, but especially and primarily for Italy.  Even those who advocate that Italy leave, such as Joe Stiglitz, acknowledge the high costs of doing so. And many economists – including this one - would disagree that Italy would be really better off outside the Euro (the most hilarious idea seems to me that the new currency could be purely electronic, in a country that seems to very much like cash for a variety of reasons).  Staying in the Euro, however, might just push Italy further down the vicious cycle of low growth resulting in migration of skilled young labour and more populism, which in return depresses growth further.

What are the options?  Simply moving towards full fiscal union and turning national sovereign debt into joint sovereign debt is politically neither feasible nor desirable at this stage (while it might be to the liking of populists across the debtor countries of the Eurozone it would strengthen substantially populists in the creditor countries, especially the AfD in Germany, who are again screaming and yelling about the mis-understood Target 2 imbalances). Only baby steps can be taken towards fiscal union. But a solution for the high degree of Italian debt has to be found.  While observers point to high local holdings of Italian sovereign bonds as buffer against creditor runs, these holdings are again in the banking system - the sovereign-bank doom loop is very much alive and kicking! 

So, there are no obvious easy solutions. But there are steps policy makers can take - ranging from (i) addressing the unhealthy concentration of government bonds on banks' balance sheets through concentration limits, (ii) expanding the supply of safe assets through ESBies, and (iii) moving away from national banking markets to a European banking market, which requires both the completion of the banking union but also a more open attitude towards cross-border mergers of "national champions" within the Eurozone. All of this can help reduce credit constraints especially in the periphery countries and reduce the denomination fear for bank depositors.  Most importantly, progress on other dimensions of the European project - migration crisis, standing up to Bully Trump in the transatlantic trade war, and getting a head start into a Eurozone budget – can be helpful to reduce political tensions and reduce uncertainty.

More than ever, however, political unity and comity in finding solutions and rekindling the European spirit is critical.  At a time, when outside (Trump and Putin) and inside forces (populists across the block) are doing everything in their power to push the European Union towards break-up, the value of the European Union for its citizens has to be shown. Easier said than done, but that is where political leadership comes in.

9. Jul, 2018