Scott Sumner  

The second domino

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Soon after the Brexit vote was announced, I made this comment:

This time around the UK was probably hurt somewhat; British stocks are down around 4% as I write. But French and German stocks are down 7% to 8%. The markets in southern Europe are down 10% to 15%. Brexit's most powerful effect is to make the eurozone crisis worse, by increasing doubts as to whether the eurozone will stay together. By analogy, the 1931 UK decision to leave gold made things worse for the rest of the gold standard, indeed a surge of public and private gold hoarding over the next few months drove global commodity prices sharply lower.

While the pundits were talking about the UK, the markets immediately saw that the real risk was in southern Europe. Unfortunately, it looks like the markets and I were right. Now the second domino is teetering:

As Europe reels from the effects of the United Kingdom's Brexit vote, there's fresh anxiety about another referendum coming up in a major EU country.

It won't be a vote on whether to remain or to leave the European Union, but on Italy's constitutional reform package. Italian Prime Minister Matteo Renzi says the reforms -- which would simplify and accelerate the passage of laws -- are long overdue and will finally bring an end to decades of his country's notorious revolving-door governments.

But Italian analysts say the October vote could turn into a referendum on the Italian government itself -- and could prove as much of a boomerang for Renzi, who has been prime minister for 2 1/2 years, as the U.K. referendum has been for David Cameron.

Complicating matters further are Italy's banking problems. Italy's banks are burdened by $400 billion in bad loans, one-third the eurozone total. These problems predate the arrival of Renzi's center-left government, but they have become a politically explosive issue after thousands of small depositors were wiped out at four regional banks over the last year and several savers who lost all their money committed suicide.

Many analysts warn that with its shaky banking system, lackluster growth, high unemployment and a growing wave of anti-establishment public sentiment, Italy is on the brink of a major crisis. The trigger could be Renzi's constitutional reforms referendum.

The media are now full of reports that Italian banks are in trouble, and could push the entire eurozone into crisis:

Italy is on the cusp of tearing Europe apart but the economic and political crisis brewing in the nation is largely going unnoticed. . . .

"If the referendum is rejected, we would expect the fall of Renzi's government. Forming a stable government majority either before or after a new election could become extremely challenging even by Italian standards," Deutsche Bank analysts led by Marco Stringa said in a note to clients in May. Fears that the reforms will be rejected have intensified since the eurosceptic vote won in Britain.

Here's what could happen if the referendum fails:

The destabilizing potential of such an outcome causes deep anxiety in European capitals, because the party likely to benefit most from early elections is the anti-establishment 5 Star Movement.

Founded seven years ago, it sprang from a satirical blog started by comedian Beppe Grillo. The party won 19 out of 20 cities -- including Turin and Rome -- in local elections held on June 20.

Analysts attributed the 5 Star Movement's success to a wave of popular anger with entrenched political elites and insecurity over economic stagnation and the growing presence of migrants. Unlike the overtly right-wing, xenophobic parties gaining ground in other parts of Europe, the 5 Star Movement won votes in these local elections across the political spectrum, appealing to voters on the right, center and left. . . .

Grillo has repeatedly criticized what he sees as excessive restrictions imposed on eurozone member states and has vowed to push for an Italian referendum on whether to remain in the eurozone. Should that ever come to pass and a "no" vote win -- returning Italy to the lira as its currency -- German economist Wolfgang Munchau, writing in the Financial Times, predicts a devastating outcome: "An Italian exit from the single currency would trigger the total collapse of the Eurozone within a very short period."

He also warns: "It would probably lead to the most violent economic shock in history, dwarfing the Lehman Brothers bankruptcy in 2008 and the 1929 Wall Street crash."

Fortunately America remains a rock of political stability, not susceptible to the appeal of clownish buffoons with no governing experience who don't fit neatly into left and right categories, and who favor breaking up the EU.

Seriously, I view the ECB as the key to the crisis. I certainly don't think ECB policy should be aimed at rescuing Italian banks, but the eurozone desperately needs much faster NGDP growth, even if the Italian banking system were in fine shape. And faster NGDP growth would have the side effect of boosting the Italian economy. Easier money in the US would also help, but this is primarily an ECB problem, which they have to fix.

If everything unravels in Europe, with the EU collapsing and nationalistic parties taking over, there will be plenty of blame to go around. But the primary culprit will be the ECB, which has held the eurozone in a monetary straightjacket since 2008, with far too little NGDP growth for a healthy labor market, or a healthy financial system.

Let me try to head off some comments that might talk about individual countries. As far as the ECB is concerned, the health of individual countries (including Germany) is TOTALLY irrelevant. What matters is the eurozone as a whole, where monetary policy has been and is still far too tight.

PS. When I read this sentence:

The destabilizing potential of such an outcome causes deep anxiety in European capitals . . .
I immediately thought back to my research on the Great Depression, when I read dozens of similar news reports in the New York Times. Here's a brief excerpt from my book, discussing late 1929:
In late October it appeared unlikely that the German petition [to repeal the war debts agreement] would be successful, and thus it is unlikely to have been a significant contributor to the October crash. An October 29 New York Times headline prematurely called the "Anti-Young Plan Vote a Nationalist Rout," and then six days later had to backtrack with a report that the nationalists had surprised everyone by collecting the 4 million signatures necessary to force a referendum on the Young Plan. At the same time, the Briand government in France was replaced by a more hawkish regime headed by Tardieu. The weak opening on the German Boerse on Monday, November 4, was attributed to both the German referendum and to the gains made by reactionaries in France. And the U.S. market, which had been widely expected to open higher, instead plunged by 5.8 percent.
Guess who supported the agreement to tear up the German war debts.

Comments and Sharing

COMMENTS (13 to date)
Michael writes:
Guess who supported the agreement to tear up the German war debts.

J.M. Keynes?

bruce writes:

I was going to go with D Trump, but I think he is referring to Hitler

Scott Sumner writes:

Michael and Bruce, Yes, Hitler was one of the nationalists who favored the referendum.

Mark Bahner writes:

Guess who supported the agreement to tear up the German war debts.

Bernie Sanders?

No, now I remember...that was German students' debts.

robert writes:

A little different, since he had the support of the Monarchists. A guess one parallel would be that he received preferential from the government, i.e. the judiciary, for clearly breaking the law. He served only nine month in jail for a coup to overthrow the government, i.e. the Beer Hall Putsch.

So, you would prefer the economic policies and economic results of Cristina Kirchner over Silvio Berlusconi? ;-)

It seems to me that Italy has two problems. First, the regulatory environment is decreases economic opportunity. Did you see the episode of top gear where the drivers were fined not for speeding in a Ferrari and Lamborghini but for working on a Sunday? Second, it seems that they have too much fiscal stimulus, which has resulted in the large number of non-performing loans and outstanding debt. Similar to Don’s point about Hillary’s tuition plan, “Hillary Clinton is expanding her plan to force some Americans to pay all the tuition expenses of other Americans”, the Italian government forces some Italian to pay other Italians to vote for them. Is the plan for targeted NGDP to increase the money supply to provide a real but not nominal haircut to the loans outstanding while also providing a haircut to the people who are owed the money, i.e. savers? Would targeted NGDP lead to improved underwriting standards and improve decision making on how the funds are invested? Wouldn’t a better solution be the structural reforms that were implemented under Schroder in Germany?

I know that the defense department front loaded their contracts in the 3rd quarter of 2012, which increased GDP, since government expenditures go directly into the calculation of GDP. GDP went down by a similar figure in the 4th quarter of 2012. I’m just not sure how that benefited the economy, i.e. the people living in the United States. Outside of a liquidity issue where businesses are not able to borrow money, how would it grow the economy if the costs running a business are prohibitively expensive?

marcus nunes writes:

"As far as the ECB is concerned, the health of individual countries (including Germany) is TOTALLY irrelevant. What matters is the eurozone as a whole, where monetary policy has been and is still far too tight."

Luca1000 writes:

Nothing new regarding Italian banks (well, I'm Italian): they have been underperforming their European peers for a long time. In 2014 they were among the worst in the EBA stress tests; since beginning of this year they have lost almost half of their value, even before Brexit. Main problems: low profitability and high NPL levels. They are mainly due to a combination of:

1) poor performance of the Italian economy: low productivity, low competition, etc. etc., therefore low growth (well actually no growth at all).

2) bad lending choices: the banking system is still very much intertwined with the political system. Until 1990, more than half of the Italian banking sector was somehow public; the EU forced the privatization of the sector, but Italian creativity managed to keep a strong connection between politics and the lending activity, especially (but not only) for smaller banks which now are struggling a lot. And the biggest banks (not in good conditions themselves) are called to step in to share the burden. Italian politicians pretended everything was fine at the beginning of the crisis and now are screaming against the EU because they are not allowed to increase the already high Italian debt in order to put money in the banking system. Capital increases and earning retention are also hindered by the willingness of the so-called “fondazioni bancarie” (politically-charged semi-public institutions owning most of the Italian banking sector) to keep their control and the dividend flowing, hoping in the final intervention of the State or the EU to foot the bill in the end. More on “fondazioni bancarie”:
Italian regulators were also happy to turn a blind eye on all the troubles of the Italian banking system. Luckily ECB and EBA are now involved and they are not complacent – unfortunately a bit too late.

3) very long recovery process, thanks to a incredibly slow judicial system: it takes on average 6-7 years to work out a bad loan in Italy, against the European average of 2-3 years (there’s an excellent study from the ECB I think on the topic, but I cannot find it now).

The Italian economist Silvia Merler has a good series of posts in English on Italian banks in the Bruegel think tank’s blog:

Apologies for the long comment!

Lorenzo from Oz writes:

I find this disconnect between the EU-as-good-thing and ECB-as-economic-vandal odd. The inadequate accountability of the EU leads to the disastrous policies of the ECB. The way the EU allows politicians in member states to play pass-the-parcel with policy then leads to poorer policy in the member states. Which leads to the economic and social alienation which created Brexit and the rising "angry votes".

Including trying to do too much centralised policy over too much socio-economic and cultural diversity. (Something that also bedevils US politics, of course.) Noting that concerns over immigration do not seem to be either race or economic based (at least not in the US).

The European Economic Community was a good thing: the EU it became, not so much. Especially if one considers the human costs of the Euro.

Benjamin Cole writes:

Good post.

The ECB is an unaccountable nightmare, devising policy for a region far too diverse to have one central bank.

Did someone say central banks should be independent? Yes, look at the ECB! How wonderful! Let us have a World Central Bank run from the top of Mt. Olympus. With the expressed obligation to only limit inflation. They know what is best for us.

Egads. Central banks should be national, and report to elected leadership.

Democracy is messy, frustrating. It is a terrible form of government, until you try the second-best way.

Scott Sumner writes:

Robert, I agree that Italy has enormous supply side problems, which are even bigger than the demand side problems. (Indeed I've posted on this issue.) But there is a real concern that demand could soon plunge in the eurozone, triggering an even worse situation.

Luca1000, Thanks, that's very informative.

Lorenzo, Yes, the ECB has tried to do far too much. The question is where do we go from here? And how do we avoid a financial collapse?

Lorenzo from Oz writes:

Scott: excellent questions. But if the EU continues to operate as if policy is just "applied knowing" and making-do with (at best) very narrow social bargaining, it is just more of what created the problems in the first place.

As an aside, what bothers me about the woe-is-us commentary on nationalism, is that goes back to treating the people(s) of Europe as if they are the problem, and that is where thinking went wrong in the first place.

James Alexander writes:

Journalists love hyperbole. Stock markets are quite volatile but don't always provide the best guide to the rate of growth in NGDP. Sometimes it is best to look at the facts of NGDP.

The facts show NGDP growth is respectable and rising in the Euro Area, even if still much lower than necessary to get it back to the pre-2008 trend, especially for Italy. But current rates are what you would expect from relatively loose monetary policy that is seeing Euro Base Money grow at 40%+ YoY.

fogcity writes:

Seems that central banks are supposed to provide liquidity after the collapse to hasten the recovery, not to endlessly prevent an adjustment of prices to demand conditions.

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