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Sunday, May 18, 2014

On The Trail Of Italian Debt

Looking for trends and correlations in that landslide of economic data which arrives, day in and day out, on our desks is normally something akin to trying to find a needle in a very large and raggedy haystack. From time to time, however, some things are just to obvious not to be noticed, like the ever rising levels of debt on the EU periphery and the growing demand from political leaders there for some kind of QE type initiative from the European central bank, for example. Sure, there is no obvious causal connecting here - the missing "middle term" linking the two would probably be all that ongoing deflation risk - but the inability of governments to contain their debt levels is a consequence of having low growth and low inflation, as is the wish being ever more insistently expressed by Southern Europe's political leaders that the ECB were more like the Bank of Japan.

In this context the latest batch of Euro Area GDP numbers must have come like a bucket of ice cold water thrown across the luke warm recovery hopes of policymakers in Frankfurt, Brussels and Berlin. Only the German economy put in a really impressive performance (0.8% quarter on quarter). Spain's economy also did well, but the 0.4% quarterly growth failed to convince due to the fact that the main influences on the number were a 1.2% fall in imports and a 0.4% negative inflation calculation (see my analysis here).

France's economy stagnated, but more worryingly for policymakers core Europe countries like Finland (minus 0.4 q-o-q)  and the Netherlands (minus 1.4%) failed to shake off their long running recessionary drag, while periphery growth laggards like Portugal (minus 0.7%) and Italy (minus 0.1%) fell back again into negative growth territory. Clearly the Euro Area seems to be stuck in some form of secular stagnation, a feeling which is only confirmed by the very low inflation levels we are seeing and reinforced by the fact that both Portugal and Italy have suffered from chronically low growth rates since the start of the century.

Nothing which has happened since the crisis suggests this low trend growth rate is going to to improve radically, in fact there are good reasons to think that trend growth might even deteriorate further: both countries have higher debt loads (public and private combined) than when they entered the crisis, and in both cases working age populations have now started to decline. (See an excellent review of the Portugal situation by Valter Martins here and here).

Not only do we have a legacy then of high debt and low growth, a new problem has emerged: low inflation or even deflation. Italy's inflation has fallen to very low levels, while Portugal now has experienced 3 consecutive  months of negative annual inflation.

The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP (or GDP at current rather than constant prices). If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even contract (as has happened in Japan). This phenomenon has already started to make itself felt in Spain, as the following chart from the Spanish statistics office makes plain.

 We don't have any detailed data for Spain's Q1 2014 performance yet beyond the Bank of Spain initial estimates, but if this estimate is confirmed by the National Statistics Office then it is unlikely than nominal GDP at the end of March was much above the level it was at last June, despite the recovery in economic activity.  Which is one of the reasons that Spain's debt to GDP level has been rising so rapidly in the last 12 months. Naturally something similar has been happening to Italian debt, which rose from 127% of GDP in December 2012 to 132.6% GDP in December 2013, despite the fact the country only had an annual fiscal deficit of only 3% of GDP. Italy's nominal GDP fell in both 2012 and 2013, largely due to the sharp drop in economic activity. Nominal GDP may continue to fall in 2014, but this time because the GDP deflator is negative. If this happens the debt level will continue to rise confounding hopes for a turnaround in the dynamic.

Italy's situation is to some extent replicated in other countries on the periphery (Ireland sovereign debt to GDP 124%, Portugal 129%, Spain 93.9% and Greece 175%) since almost all official forecasts anticipate an imminent turnaround in the debt dynamic. If secular stagnation and ultra low inflation really set in this turnaround is going to be impossible to achieve and Europe's leaders will need to decide what to do about it. 

Italy is a good case in point here, since if debt were to climb towards 140% of GDP and beyond, then someone somewhere would surely have to officially recognize that it was not on a sustainable path. Cases like Greece and Portugal are to some extent manageable from an EU perspective since the economies are small enough for EU leaders to engage in some sort of extend and pretend via low coupons and long horizon maturities. But Italy's debt is simply too big to be manageable in this way.

So Italy's government faces a dilemma. Complying with its EU deficit and debt obligations may well mean that the deficit comes down but in all probability the debt level will go up (given the weak nominal GDP effect). Not complying with them opens the possibility to slightly more growth (and possibly stronger inflation) but naturally the debt level will rise. It's a sort of damned if I do and damned if I don't situation, since either way the debt burden rises.

From the point of view of the country's political leaders though, it is obvious that austerity today has costs (and few visible benefits) while deficit spending may bring some short term benefit at the price of hypothetical longer term debt issues. It shouldn't surprise us then if they go for the latter, especially since Japan's political leaders have been widely applauded for doing something similar.

Naturally, since the difficulties the onset of secular stagnation will produce for heavily indebted countries with ageing and shrinking workforces are not widely understood, hints that deficit objective relaxation calls are growing have not been well received everywhere.  The FT published details recently of a document jointly issued by the German and Finnish finance ministries which strongly rebuked Brussels for easing austerity demands, citing in particular the additional  flexibility given to France and Spain for reducing their budgets to within EU deficit limits. Although given the latest performance results for the Dutch and especially the Finnish economy ("Once Europe's lead preacher of budget prudence, Finland loses righteousness"), Germany may find itself increasingly out on a limb if it maintains this posture.
“Since 2012, the commission has substantially changed the way it assesses whether a member state has taken ‘effective action’ to comply with [EU budget rules],” the memo states. “The recent methodological changes imply the risk of watering down the newly strengthened [rules] at its implementation stage.”
As might have been expected, Matteo Renzi  has not been slow in coming forward to seek similar treatment for his country (See "Italy request to push back budget targets dismays Brussels" FT April 17). According to the newspaper the country's finance minister, Pier Carlo Padoan, sent a formal written request to the commission on 16 April seeking authorisation for a change in objectives. Citing the “severe recession” that set Italy back in 2012 and 2013, Mr Padoan wrote that Italy wanted to “deviate temporarily from the budget targets” and that because of “exceptional circumstances” (my emphasis throughout) the government had decided to accelerate the payment of arrears owed by the public to the private sector by €13bn, which would increase the debt to GDP ratio in 2014. The trouble is that these "temporary factors" and "exceptional conditions" seem to arise with a predictable regularity in Italy's case. The country is currently aiming for a balanced structural budget in 2016 rather than 2015 as agreed with Mario Monti’s technocrat government in 2012. A year earlier, then prime minister Silvio Berlusconi had promised a balanced structural budget by 2013.

Naturally Brussels was not amused (“Brussels is very upset,” one senior Italian official told the FT) and issued a statement to the effect that Italy's economic woes continued to require strict monitoring and "strong policy action".Such findings form part of the EU's new system of economic policy coordination and are aimed at preventing a repeat of the euro zone's debt crisis. The system requires governments to undergo repeated scrutiny of their economic performance to determine if there are economic trends and policies that are sowing the seeds of future problems.

But as Mathew Dalton pointed out in an article in the WSJ (Italy's Plea for Leeway Puts Brussels in a Bind) the problem facing Berlin and the EU Commission is far from straightforward.
The problem of Italy's debt is shaping up to be a key test of the European Union's complicated new system for controlling the finances of its member states. 
 The new budget rules are proving to be a source of conflict, pitting harder-line countries such as Germany and the Netherlands against broad swaths of Southern Europe that want more leeway on their budgets. Standing in the middle is the European Commission, the EU's executive arm, which has gained stronger authority to enforce the new rules.

Now it faces a crucial decision: Does it insist on a tough enforcement of the rules that could potentially plunge the Italian economy back into recession? Or does it give Rome some flexibility and risk undermining the new system that Brussels fought hard to establish to prevent a repeat of the region's debt crisis?
As Dalton points out the Commission will be wary of enforcing any rule which may undermine Matteo Renzi's credibility, aware as they will be that most of the alternatives are likely to be (from their point of view) far worse. Further, aside from the likely strong performance of Beppe Grillo in the forthcoming EU parliament elections the country is becoming increasingly eurosceptic (Italy turns from one of the most pro-EU countries, to the most eurosceptic ).

Secular Stagnation or No Secular Stagnation, That Is The Question

Evidently members of the EU Commission, ECB governing council members, or senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. Secular stagnation is at this point more akin to a theoretical research strategy than a template for policymaking, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. But the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (or here, or here) and if it doesn't what happens to all the accumulated debt?

Basically we are at the point where no easy answers are available, and where the best step we could take would be to try to start asking some of the right questions. Will, for example, unconventional Keynesian policy work as advertised in the case of declining-working-age-population induced secular stagnation? Paul Krugman seems to assume it can, when he asks himself whether there are "structural changes in Europe that arguably will lead to persistently lower demand unless offset by policy?" Exactly which policy/policies are we talking about here?

Larry Summers appears to take a similar view (Why stagnation might prove to be the new normal). But both economists are far from being unambiguous about the situation. Summers concludes his piece by saying that "the risk of financial instability" (being provoked by sustained non-conventional measures like Abenomics) "provides yet another reason why preempting structural stagnation is so profoundly important".

Europe, unfortunately has now been left to drift well  beyond that early "preemptive" stage. Paul Krugman concludes his review (Stagnation Without End, Amen) of what has to be the most substantial examination to date of the theoretical issues involved (Gauti Eggertsson and Neil Mehrotra's "A Model of Secular Stagnation") by asking himself "whether there is a possibility of sustaining the economy with permanent fiscal expansion". Naturally, the answer is important since if there isn't the validity of the whole Keynesian model which PK himself has been working with would be called into question. A point which is entirely lost on those who reject the secular stagnation hypothesis outright (I won't let mere facts get in my way) for inbuilt ideological reasons. As I say, finding a way forward to manage this problem is very much a matter of which questions you allow yourself to ask.

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