Italy redux

A few days ago, I noted that the formation of a populist government in Italy exposed many of the fault lines in the single currency area. I stand by that – except in one crucial respect: The government deal we thought had been ratified came undone after the president vetoed the selection of a Eurosceptic finance minister. So now it is a domestic political crisis as well as a problem for the single currency area. Should we worry?

In my view, it is highly unlikely that Italy would ever leave the euro zone. It may allow policymakers to take back control of monetary policy but as the Brexiteers discovered in the UK, “taking back control” is an illusory concept. The first thing the Italians would have to worry about in the event of reintroducing their own currency is how far would it fall, which provides a partial answer to the second question: by how much will real incomes be squeezed? Moreover, although the bulk of Italian debt is held by domestic investors, foreign investors would dump whatever they have and the stock market would also take a beating. And the already-fragile banking system would come under further strain. For the foreseeable future, Italy will remain in the single currency area. The alternative is too awful to contemplate.

But plans by French President Macron to try and get the euro zone back on track appear to be running into the sand. Macron proposes more inclusive solutions including establishing a European finance minister; a fund to support investment and turning the European Stability Mechanism – established in 2012 as a system to provide financial assistance for member states in difficulty – into a European IMF. In order for him to make progress with these plans requires German political support but following last year’s general election which weakened Angela Merkel’s position, she seems less inclined to support Macron’s efforts.

A letter from 154 German academics, published in the Frankfurter Allgemeine Zeitung last week demonstrated the depth of German opposition. They warned that the euro zone should not be turned into a liability union and listed five main arguments opposing Macron’s plans: (i) The use of the ESM as a backstop for the bank recovery programme will reduce the incentives to clean up banks' balance sheets; (ii) If the ESM is transformed into a "European Monetary Fund" (EMF), it will be under the influence of countries that are not members of the euro zone which will reduce the controlling influence of the Bundestag; (iii) A common bank deposit guarantee scheme will socialise the cost of previous mistakes made by banks and governments; (iv) The planned European Investment Fund for macroeconomic stabilisation would lead to further transfers and loans to euro zone countries that have failed to take necessary reform measures in the past; (v) establishing a European Minister of Finance with power over fiscal policy would further politicise the role of the ECB.

They conclude that “the liability principle is a cornerstone of the social market economy. The liability union undermines growth and threatens prosperity throughout Europe … It is important to promote structural reforms instead of creating new lines of credit and incentives for economic misconduct .... The euro zone needs an orderly insolvency procedure for states and an orderly withdrawal procedure.” We should not dismiss these views out of hand – after all, AfD started as a project backed by some members of the academic community. It is somewhat ironic that the academics endorse the proposal of the prospective Italian government that an orderly withdrawal procedure be set in place. But the letter also laid bare that the signatories are as much concerned with looking after the German national interest as with laying the foundation stone for a stronger euro zone – note in particular point (ii).

And this is a problem that lies at the heart of the euro zone – indeed, the whole of the EU. It is what drove Brexit and prompted the Italian electorate to vote for a populist government. EU citizens simply do not see why they should make further sacrifices for a project that appears very remote to them. Admittedly, they can touch euro notes and coins, so in that sense monetary union is tangible. But the political sacrifices required to make it work are seen as an unnecessary step.

Perhaps – as I noted in a post last summer – the single currency was simply a step too far for the EU. There again, European politicians have never made a sufficiently compelling case for the EU. It has been taken for granted for too long. If Brexit was a wake-up call for politicians to sell the European vision, they are taking a long time to learn the right lessons. And so far they are failing.

Italy exposes the fault lines (again)

We knew that the Italian election, held almost three months ago, had the potential to cause problems in the euro zone but having survived the French and German elections last year, most investors thought we would be able to muddle through in Italy. It seems we were wrong. Although the Five Star (M5S) populist movement won the most votes, it was widely assumed they would not be able to get anyone else to work with them to form a government. In the end they managed to stitch up a deal with the far-right League, which had previously existed as the Northern League and campaigned for separation of northern Italy from the south, to form a coalition that most investors believed to be the worst possible outcome.

Italy now has a very inexperienced government which has discussed implementing a tax-and-spend policy which has been estimated in some quarters to cost up to 3.5% of annual GDP. Not surprisingly, this has sent alarm bells ringing in Brussels and Berlin as the Italian government prepares to drive a coach and horses through the fiscal rules that underpin the single currency. There was even a suggestion a couple of weeks ago that Italy would ask the ECB to wipe out €250bn of debt as well as set up procedures allowing EU member states to exit the euro, which is of a piece with the Eurosceptic views of M5S . Having experienced a near death experience in 2012 with a rerun in 2015, it is hardly surprising that serious questions are being raised once again about the stability of the euro.

In truth, Italy has always been the fault line running through the single currency project. Not only were its deficits flattered by financial accounting manoeuvres to get it below the 3% of GDP threshold in order to qualify for EMU, but its high debt levels were completely ignored. Recall that debt was supposed to be below 60% of GDP, or falling at a sufficiently rapid pace, in order to meet the qualifying standard. Neither was met (see chart). However, this was not a problem for the first decade of EMU – but then the crash of 2008 happened. To think that the problems in Greece almost brought the single currency to its knees. Given the vast size of the Italian debt market, problems in Italy could shake the project to its core.

However, much of the admonishment heaped on Italy, particularly from Germany, misses a vital point. EMU will not survive in the longer-term without a system of fiscal transfers – something that German taxpayers are dead set against. It is understandable that thrifty northern Europeans do not want to see their tax contributions used to bail out the more profligate. But without such a mechanism, differences in economic performance between nations will shake the euro zone apart in the same way as fixed currency systems such as the Gold Standard and Bretton Woods ultimately collapsed. The fact that the euro is underpinned by the ECB gives EMU a safety mechanism that neither of the other systems had but, short of the monetary financing of debt, it cannot provide sufficient long-term support to offset the strains in the system.

Whilst Italy clearly does require growth-boosting reforms – it has been one of world’s worst economic performers since 1999 in terms of GDP growth – it is not unreasonable for governments to think about how to use fiscal policy as an active policy instrument once again. We may question whether some of the government’s policies are feasible or desirable (a summary of the policies can be found in this FT article) but politicians are right to ask whether they should continue to operate a fiscal policy which is subordinate to the needs of monetary union.

Perhaps the biggest danger the Italian situation poses is that it really could pose an existential threat to the single currency. Italy is bigger and far more economically important than Greece and cannot so easily be bullied into accepting policies imposed from outside. If, for example, it were to set up a procedure to exit the single currency this would cause investors to be highly concerned about the long-term stability of the project, even if it were never implemented. As it is, Asian investors already do not go near Italian debt – they might be more wary of any euro debt if there is a threat to the currency’s existence.

Italy will not exit the euro, of course: The self-imposed damage this would cause would far outweigh any benefits. But unlike 2012, when the ECB promised to do “whatever it takes” to preserve the single currency, it may be less willing to act as a backstop this time around. Six years ago, the problems were largely the result of prevailing global conditions in the wake of the global financial crisis. Any shocks to the system triggered by conscious Italian policy decisions are unlikely to be met with such unequivocal support, for this would send a signal that countries can ignore the rules with impunity and still be bailed out. Brexit demonstrated that the unthinkable can become reality. We should not be too complacent about the wider implications of Italy’s populist government

More Frankenstein's Monster than Schrödinger's Cat

Last week, the cabinet agreed to a ”backstop” that would see the UK aligned to EU tariffs after 2020 if the two sides cannot agree on customs arrangements. Predictably, the Brexiteers in government were concerned that this might represent an attempt to remain in the customs union, although the prime minister appears to have convinced them it is a backstop that is unlikely to be triggered. I would not be so sure about that.

The government essentially has two plans on the table ahead of the EU summit in late June. Theresa May’s preferred plan is the customs partnership in which the UK collects external tariffs on behalf of the EU. Under this option, goods would cross borders with tariffs levied at the highest of the UK or EU rates with refunds claimed at a later date (in the same way as VAT is treated today). This would require far more cross-border tracking than is currently necessary, which would hugely increase the administrative burden. This plan has been dismissed by EU negotiators as “magical thinking” and it is opposed by Brexit supporters who view it as maintaining ties with the EU that they wish to see ended.

Consequently, they favour the so-called maximum facilitation (max fac) option in which the application of technology and the implementation of a “trusted trader” scheme will obviate the need for a physical border. But the technology to ensure that such a procedure can be implemented does not yet exist. Moreover, it would require the EU to put a similar system in place in order to work and it has been dismissed out of hand.

On the assumption that neither the customs partnership nor the max fac plans are acceptable to the EU, the backstop certainly has its attractions. Whilst it would give the UK a bit of breathing space to iron out its own internal difficulties, it may not be an easy sell in Brussels. Although the prime minister’s plan assumes that current arrangements can continue beyond end-2020, the EU may well decide to play hardball since it regards the border problem as a Northern Irish issue and appears to have no interest in applying a UK-wide solution in order to resolve it. In addition, it would fly in the face of the EU’s desire to set a limit on the transition period. But a more serious objection from the EU’s perspective is that it would allow the UK to remain a “quasi member” of the EU and thus escape the adverse consequences of a hard Brexit.

It is thus pretty obvious that a resolution to the Irish border problem is not imminent. Moreover, the UK government appears to be furiously back-pedalling on its more aggressive positions because it realises the intractability of the problem. But there is nothing new in any of this. I recently came across a filmed presentation that I gave in March 2016 when I explicitly warned that a Brexit vote would simply swap one set of problems for another and that no thought had been given by Brexit supporters to the consequences of their actions. Almost two years on from the referendum, the questions I am increasingly asking myself are “who owns Brexit” and “what do its supporters want out of it?” It seems to me that government rhetoric has pandered to the demands of those who want to pull up the drawbridge against the outside world whilst simultaneously trying to placate those who believe Brexit is a great opportunity to promote free trade. The trouble is that no one is satisfied – primarily because no-one in government is prepared to take responsibility for implementing a policy which is likely to have major adverse economic consequences.

What the government wants is a Schrödinger’s Brexit where we are simultaneously both in and out of the EU, thus delivering all the benefits of membership and all the gains from being outside. Schrödinger’s Cat was, of course, a thought experiment. And the further away we move from the heated rhetoric of spring 2016, the more it looks like the referendum exercise was a giant experiment in how not to conduct policy. More Frankenstein’s Monster than Cat.

Will markets feel so brave without central bank protection?

Perhaps one of the more surprising aspects of markets in recent weeks has been the extent to which they have remained resilient in the face of what might be termed extreme provocation. Admittedly there was something of a wobble around the time President Trump decided to end US participation in the Iran nuclear deal, but on the whole they have remained remarkably quiet. Add in the prospect of unrest on Israel’s borders and the ongoing situation in North Korea, and it is clear that there are plenty of geopolitical threats to worry about (not to mention the very fact that Donald Trump occupies 1600 Pennsylvania Avenue).

Not so many years ago, these were the kinds of issues that would have investors running for cover. But equity option volatility continues to ease back and is well below the levels achieved in early February which is a sign of reduced tension. Indeed, the FTSE100 yesterday hit an all-time high, although this was primarily the result of a weaker pound that boosts the sterling value of foreign currency earnings in a market which generates 70% of its revenue abroad. Nonetheless, it does raise a question of why markets can continue to remain steady in the face of numerous headwinds.

One reason is that central banks in Europe and Japan continue to provide huge amounts of liquidity. In European bond markets, the central bank remains a huge buyer and it is almost impossible to get hold of certain bonds – particularly corporate securities – due to the ECB’s actions. Against this backdrop there is little reason for markets to panic in the face of events that may – or may not – cause prices to fall. This is entirely rational behaviour. If investors believe there may be a small dip in prices that will subsequently be reversed as the central bank backstop kicks in, it makes sense to hold onto positions and thus save the trading costs associated with closing them and reopening them again. In other words, markets can be afford to be brave in the face of these threats. But how long might such behaviour persist?

In the US, the Fed has raised rates six times since December 2015, by a total of 150 bps, and it is winding down its balance sheet, so the degree of support which it once provided is being slowly eroded. We are starting to see bond yields creep up with many investors concerned by the fact that the US 10-year yield has hit a new multiyear high, returning to a level not seen since 2011 (3.128%). It is hard to say why rates have edged up so quickly of late but then it was equally difficult to explain why the long end of the curve did not respond as monetary policy was tightened. They are probably now where they should be. In the process, the differential with German Bunds has widened out to around 260 bps – a spread last seen in the late-1980s. So long as the ECB is still engaged in buying Emu bonds, there is little prospect of a substantial narrowing. But before too long – perhaps once the ECB buying programme ends – European yields will also begin to rise. Indeed, Italian yields are already edging up as political concerns mount regarding the formation of a new coalition government.

It currently feels as though we are in the midst of a phoney war as markets digest the implications of Fed tightening. They don’t want to sell because a strategy of shorting the market has not paid off over the past nine years. But as the Fed increasingly normalises monetary policy and the ECB contemplates an end to its QE programme, the special conditions which have supported valuations, and prompted a divergence in asset prices from fundamentals, may well force investors to take a closer interest in some of the global threats which are bubbling up. And they may not like what they see.

Inflation Report post mortem

The Bank of England’s decision to keep interest rates on hold today may have been what the markets were ultimately expecting – after having been conditioned between February and late-April to expect a rise – but I can’t help thinking that the late change of mind has caused more problems than was strictly necessary.

The forecast upon which the decision was based was not hugely different from that presented in February. Growth is a bit weaker this year but that is primarily due to the weakness of Q1 GDP. Inflation is moderately lower, but we are only talking about a few tenths of a percent. However, the BoE did go to great lengths to persuade us that some things have changed – notably the fact that the pass-through from sterling’s depreciation in 2016 has operated more quickly than expected, and as a result CPI inflation does slow more quickly in the early part of the forecast period than in February. As they pointed out, the March inflation figure (2.5%) turned out some 0.4 percentage points lower than expected three months ago (when the last observation was the December inflation rate of 3%).

As noted a couple of weeks ago the weakness of Q1 GDP, which at 0.1% q/q undershot even the most modest of expectations, was the key factor in the decision. In the past, the Bank has tended to raise rates only when quarterly GDP growth is at 0.5% or higher, so the majority of MPC members were clearly uncomfortable with tightening policy when growth is so far below this threshold.

Questions are increasingly being asked as to whether this slowdown is a one-off triggered by weather effects, or whether it marks something more serious. The ONS reckoned that the impact of the snowstorms in early March explained only part of the weakness. They may be right, but apparently this deduction was derived from a survey it sent out asking firms whether output had been affected by the snowstorms. When relatively few firms responded this was the case, the statisticians deduced that the weather effect was not so significant. In my view, and one which the BoE shares, the impact of the snowstorm was greater than the weight attributed to it by the ONS. Indeed, survey-based estimates suggest that Q1 GDP growth was higher than the initial estimate of +0.1%. The Bank believes that the figure will be revised up. That being the case, why did it simply not look through the temporary distortion? Presumably, the decision was partly based on how raising rates when the economy is going through a soft patch would play with the wider public. Or it could be that the BoE believes underlying growth is slowing.

Across the channel, we have already seen signs that the euro zone economy has lost momentum. And there is a school of thought which suggests the slowdown in UK monetary aggregates is a sign of weaker growth to come (see this FT article by Chris Giles).  It is always difficult to disentangle the direction of causality between monetary growth and real economic activity. But as Giles notes, “simple correlations show that measures of money have moved closely with the cycle this decade, raising the possibility that monetary indicators are due for a revival in economics.” But the slowdown evident in the money data is not yet evident in survey-based estimates (although last month’s retail sales activity was weak according to the British Retail Consortium). Consequently, the jury is still out on where the economy goes from here, but it seems set to continue growing much more slowly than prior to the EU referendum.

Not surprisingly, the big issue at the Inflation Report press conference was the BoE’s communication strategy. Having built markets up to expect a rate hike in May, only to backtrack in the face of the data, has led to accusations of inconsistency in expectations management. The BoE will point out, of course, that the decision was conditional – in this case on the data – so that a change of heart was the rational response. And there was a sense of testiness on the part of Bank officials when faced with intense grilling on the subject. Governor Carney sought to deflect criticism of misleading markets by referring to the fact he is trying to appeal to firms and households rather than just markets. But since markets set prices which impact on the decisions of firms and households, I am not sure I fully buy it.

However, I can see both sides of the debate. The BoE makes conditional forecasts and when the conditioning assumptions change it is entitled to change its view. The press in particular may not always understand the nature of a conditional forecast. Arguably, however, the BoE has to work harder to make sure that the conditional nature of its forecasts is better understood.If the BoE wants to improve its communication strategy, this might be a good place to start. But there is a wider problem. The MPC is comprised of nine members, each of whom is independent. Given the tendency of economists to disagree on any given issue, one could be forgiven for suspecting that it will prove almost impossible to get the MPC to speak with one voice, thus reducing the effectiveness of the forward guidance strategy.

Immigration as a problem of time inconsistency

Time inconsistency is a much-used term in economics and describes a situation where a policymaker announces a policy option only to renege on it later when it is evident that the costs of adhering to the original policy are higher than the costs of cheating. It was originally popularised in the macro literature in the context of monetary policy whereby a central bank announces a target – a money supply growth rule for example – only to find that the costs of maintaining it are too high because it requires implementing a policy which is too tight (or loose) for overall economic conditions.

But it goes way beyond monetary policy and I was struck recently by how a couple of the big items on the UK government’s agenda can be described in terms of the time consistency problem. One is the decision to leave the EU. Given the closeness of the referendum vote and the degree of opposition to the decision, together with the fact that younger voters – tomorrow’s older generation – are generally in favour of remaining, it is possible to imagine a situation in which the UK either reneges on its commitment to leave or reapplies at some point in future. If that were to happen, it would render today’s shenanigans regarding Brexit negotiations a time inconsistent set of policies.

However, the time inconsistency issue particularly came to mind in the context of the recent scandal regarding the first generation of immigrants from the Caribbean in the late-1940s and 1950s. To recap, many thousands migrated to the UK seeking work – and let us not forget, this policy was welcomed as a way to alleviate post-1945 labour shortages. Crucially, they were entitled to come to the UK without having to give up their original nationality, thanks to the passing of the 1948 British Nationality Act, which granted UK citizenship to those from Commonwealth countries. Consequently, many people simply did not feel the need to formally apply for UK citizenship – it was conferred upon them. But the 1971 Immigration Act changed the law to grant only temporary residence to most people arriving from Commonwealth countries which came into force in 1973. However, people born in Commonwealth countries (and their dependents) who arrived before 1973 were given indefinite leave to remain.

So far, so uncontroversial. But the time inconsistent element of immigration policy can be dated to May 2012 when then-Home Secretary Theresa May declared: “the aim is to create here in Britain a really hostile environment for illegal migration.” She then steered the 2014 Immigration Act through parliament that gave new powers to help the Home Office and other government agencies make life difficult for illegal migrants. Amongst other things, this required people to have documentation to work, rent a property or access benefits. Just to complicate matters, the Home Office did not keep a record of those granted leave to remain under the 1971 legislation, or issue any paperwork confirming it. It also destroyed the landing cards (or registry slips) of first generation immigrants in 2010 as part of the drive to eliminate the huge pile of paper records in the archive.

Now you might say that this is simply incompetence on a massive scale, and I would not disagree. But what policy has done is to confer a set of legal rights on citizens only then to change the rules by insisting on a burden of proof which was never initially required. That is a classic example of time inconsistent policy. We find ourselves in this situation because of a change in the political climate – we can argue about whether government was responding to a change in voter preferences or whether it indeed fanned the flames. What we can say for certain is that government policy changed over the years, from welcoming immigrants as a source of labour to actively discouraging them.

Such time inconsistency issues are not confined to the UK. In France, for example, the Immigration Act of 2006 abolished the automatic right of immigrants to attain French nationality after having lived without authorisation in France for at least ten years (here for an overview of French immigration policy since 1945). This policy is officially designed to “restrict the immigration of unskilled workers and persons who would become a burden on the French State” but as in the UK, it is surely no coincidence that it followed a rise of popular discontent.

Whilst Germany has dealt relatively better with its Gastarbeiter policy introduced in the 1950s and 1960s, the longer term consequences of allowing in huge waves of migrants in 2015 have yet to unfold. There is no doubt that as a humanitarian gesture, it is without parallel in recent years. But the surge in support for the AfD in last September’s election suggests that not all voters share Angela Merkel’s view. The experience of the UK and France is that immigration policy – and indeed many other policy areas – can experience a 180 degree turn. Governments seeking re-election every 4-5 years may simply not be able to make promises that their successors are willing to keep and it is a reminder that nothing lasts forever – even what appear to be binding policy commitments.Jacob Rees-Mogg, Boris Johnson et al take note.