lengthy report that interested readers can find on the website of the Bank of Italy (the Italian central bank). We had a lengthy meeting with six members of the bank, which was rather refreshing in its frankness. There has been significant progress in parts of the economy, specifically in the turn-around of the balance of payments, which is now positive and which has long been an important factor in the general malaise of the peripheral European countries. The overall deficit is also being reduced, but that is pretty much where the good news ends.
For the past year, the number of people employed is down, as is the total number of hours worked. While the deficit is down, Italy still had to borrow €75 billion last year. The debt-to-GDP ratio is now at 133%. (Remember when it was “only” 120% and everybody was talking about the crisis that was going to come about?)
Italy is still in a recession and has been for over 2½ years. Prior to that time growth was anemic at best.
The optimistic goal in the bank of Italy’s projections is to get the primary surplus up to 4.2% in 2016, from 2.2% today. This bears a little explaining for most readers. You can find a very readable explanation here. Essentially it is the surplus or deficit in a government budget, not counting interest payments. A country is considered to have a “primary surplus” when it can cover all of its actual expenses other than the cost of paying the interest on its debt. What that technically means is that if you are willing to ignore (not pay back) your loans and interest, you can meet your other expenses. Economists and politicians seem to consider a primary surplus as a desirable condition, as opposed to merely being in a complete surplus.
Today it takes 5.3% of the entire GDP of Italy just to pay the interest on its debt, which is the third-largest pile of government debt in the world. By the optimistic projections of the Bank of Italy, that will go down to 5.1% in 2016, even as the total interest payments rise. That means that today Italy has to borrow about 3% of GDP every year. But in order to continue to do so, Italy must achieve significant growth in the next two years.
How do you get out of this debt trap? The easy answer is that you have to grow your way out. If you get 2% real GDP growth and can get the primary surplus well above 3%, you can very slowly make headway. In the government’s positive projections, Italy would also have 2% inflation, and the primary surplus would be 4%. Which would mean the debt would shrink by approximately 3 to 4% of GDP per year. (Remember that these are central bank projections. And then remember how accurate US Federal Reserve economists’ projections have been. Just saying.)
But is a 2% growth rate achievable? For the last 54 years, Italy has averaged just 0.6% a year GDP growth. How do you get to a primary surplus of 4%? You have to do a lot more cost-cutting, and your tax receipts have to rise. But tax receipt growth in Italy has been negative for the past few years.
And 2% inflation? Inflation is running about 0.5% now and is less than 1% throughout Europe. Furthermore, inflation has been trending down. And as the chart below from Merrill Lynch indicates, in a low-inflation scenario and with realistic growth assumptions, Italy’s debt-to-GDP in will be approaching 150% within four years. And that means interest-rate payments will be rising along with the debt.
I spoke at a banking conference in Rome on Monday afternoon. I was the last speaker on a panel in which we were asked to address the question, “How will the markets react when monetary policy returns to normal?” My answer was that we are a long way from monetary policy in Europe approaching anything that one could call normal. I used the above chart and a similar one that depicts even worse dynamics for France. Countries with spiraling debt and a growth problem need a little inflation along with some growth in order to work out of their problems. And that is not an environment that calls for normal monetary policy.
A proper response will require a change of attitude at the European Central Bank. Everyone we talked to seemed to believe that the Italian head of the ECB, Mario Draghi, was getting ready to unleash quantitative easing in the Eurozone in order to begin to bring back inflation. These were people who know him; and whether they are depending on hope or insider knowledge, they are acting as if inflation is going to become a fact.
Italy – When Hope Is a Strategy
And that brings us to my rather intriguing conclusion. The current Italian leadership has decided to deal with their problems. They’re going to try to restructure their system to the best of their ability to create opportunities for growth. They’re going to remove every obstacle they possibly can. They are going to be – or at least attempt to be – at the very forefront of a movement that will be necessary all across Europe to reform the bureaucracy and labor markets.
If everything goes perfectly – and I mean to a degree that has not been seen in Italy in a very long time – they will get their deficit and debt under control and begin to grow their way out of the problem. Anything less than perfection becomes a problem.
I generally followed up every optimistic meeting and presentation with two questions. The first dealt with the elephant in the room that nobody really wanted to talk about: “How do you deal with the rising debt and interest payments if you don’t get the growth and inflation you need?” Those of us with a little time under our belts remember the TV series Happy Days and the character Fonzie. Fonzie was almost incapable of saying the word sorry. In Italy I could not get anyone to say the words “debt restructure.” Sometimes they would look away or just ignore the question, but it was evidently a topic that was inappropriate in polite conversation.
Well, that’s not entirely true. An English hedge fund manager was quite willing to state that the Italians would be forced to restructure their debt within three years. But that’s the English for you.
And that may be the reality. At some point the debt simply becomes too gargantuan for even the most optimistic of Italians. No one wants to admit that they can’t deal with their problems; but at some point, if the Italians don’t get their perfect economic scenario, the judgment of the market is going to be imposed upon them. Today interest rates for Italian debt are at their lowest in a very long time. But if rates were to rise just 1% – let alone 2% or 3% at 140% debt-to-GDP – interest costs would quickly spiral out of control.
And then there was my second question. At the end of our presentation on Monday, I quickly dealt with my belief that France will be the next Greece. Unlike Italy, France is simply not dealing with its problems and seems to be in a state of denial. What happens when the market begins to demand higher interest rates from France and their debt becomes an even bigger problem? France has a much larger structural issue with their budget than Italy does and cannot handle nearly the debt load that Italy can. The euro, I maintained, is not so much a currency as an experiment, and will remain so until the Eurozone has dealt with the crisis that is going to ensue, starting in France.
(This was evidently a rather provocative statement at the end of the day on Monday. The head of the conference told me Tuesday evening that one of the few consensus notes coming out of the conference was that France would be the next big problem facing Europe. Well, except that the representative from the French central bank took exception. Go figure.)
“Who will lead Europe,” I asked, “when there is a crisis in France?” The Germans are going to be very uncomfortable trying to force France into the necessary reforms. Could the role of leadership in Europe actually fall to the Italians? If they make all the necessary reforms to their own economy and government, that leadership role might in fact be theirs. At some point there is going to have to be either a mutualization of debt across the Eurozone, or the ECB is going to have to be allowed to work out financing through a broad restructuring plan. Germany will have to go along or watch the euro collapse.
And upon reflection, that is the basic outline of an unspoken plan I think I see the Italians developing. Fix what we can in our own situation, and if everything works out, then great. But if not, we will have the moral high ground to provide a plan to help all of Europe move out its malaise.
They also believe that ultimately, no matter what happens, Draghi has their back. They really do intend to find out what Draghi meant when he said, “Whatever it takes.”
When I look at the choices the Italians have, the concept I have sketched above actually seems to be about the best one available. You can’t go back in time to get rid of your debt; you have to deal with the reality on the ground. So create a plan that hopes for the best but includes a backdoor in case you get the worst instead.
And if “the worst” is a restructuring of your debt after you’ve reformed your economy, then maybe that’s not so bad. Of course, there is the problem that Italians own 60% of their own debt. Their banks are loaded with Italian debt. So the word restructure is definitely laden. Which is why the Italians need a banking union. And it’s another reason why debt mutualization and the moving of some or all European debt to the balance sheet of the European Central Bank, in lieu of a classical restructuring and default such as happened in Greece, make a great deal of sense from the Italian point of view.
Things are going to be very interesting in the next season of Game of Thrones. The coming seasons of the Saga of the Euro will be just as captivating. Stay tuned.
Nantucket, New York, and Maine
I know my travel schedule always seems to change, but right now the calendar has me home for more than 12 out of the next 14 weeks. I can’t remember the last time that happened. I hope to be able to get into something like a routine at the gym and with work. I’ll be in Nantucket and New York City in the middle of July and Maine at the beginning of August. And there’s only one short trip so far in the middle of September. I’m sure September will change.
The travel gods didn’t cooperate on the return trip from Rome. We got off a few hours late, eventually landing in Chicago. American Airlines conveniently put us on a flight later in the afternoon, but then there was a little weather problem in Dallas. So we sat in the Admirals Club as they moved the departure time back 20-30 minutes every half hour or so. Eventually we got out at about 3 AM and were finally able to leave the Dallas airport at around 5:30 – without our bags, of course. Rather than the full day I’d optimistically planned, I finally got to bed at 7:30 AM and slept most of the day. But eventually the luggage showed up, and by Friday morning all was right with the world. It was time once again to begin to write this letter.
I pretty much finished it by Friday evening and decided I would get up early Saturdaymorning for one more read. Besides, I really did need to catch up on Game of Thrones.Everything was going according to plan until I sat down at my computer Saturdaymorning. Something, and our techies can’t figure out what, caused my computer to crash at 5:30 AM. And I stupidly had not saved my Word file. I know better than that. How many times have I told my kids that the first thing you do is title and save your document? Seriously. And for whatever reason, the crash happened so quickly that Word was not able to back
