Scott Sumner  

The third domino?

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Here's Wolfgang Münchau:

The largest and most important is the Five Star Movement, a party that defies the usual left-right classification. The second is Forza Italia, Silvio Berlusconi's party, which has turned rabidly anti-euro after the former prime minister was forced out of office in 2011. And the third is the separatist Lega Nord. In democratic countries, it is common that opposition parties eventually come to power. Expect that to happen in Italy too.

The referendum matters as it could accelerate the path towards euro exit. If Mr Renzi loses, he has said he would resign, leading to political chaos. Investors might conclude the game is up. On December 5, Europe could wake up to an immediate threat of disintegration.

The first domino was Brexit and the second was Trump. Will Italy be the final domino, which triggers a eurozone financial crisis?

The euro was one of the biggest mistakes in modern European history. It represents a classic example of technocratic overreach---the Greeks would say hubris. The core problem with the euro is that it's an experiment, which was set up in a fashion that is extremely difficult to undo if it fails. There is no possibility of a quick Italian devaluation; the more likely result is a massive government default, and a banking crisis.

Europe has stepped back from the brink a number of times in the past 6 years. But what makes the current situation so dangerous is that decisions are now being made by voters, and we've seen that voters are increasingly unwilling to accept the advice of the experts. (Some would say, "Hard to blame them".)

My central expectation, however, remains not a collapse of the EU and the euro, but a departure of one or more countries, possibly Italy, but not France. In the light of recent events, my baseline scenario is now firmly on the optimistic scale of reasonable expectations.
The fact that this is the "optimistic" scenario might be the single most frightening thing I've read all year. Italian government bonds are the third largest asset class on planet Earth.

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COMMENTS (14 to date)
bill writes:

US Treasuries would be #1. What's #2?

Bacon Wrapped writes:

Not really related to the content of post, but why only three figurative dominoes?

Lorenzo from Oz writes:

Remembering that the euro was not a sin of globalisation, but of internationalisation. I can see quite a series of revolts against internationalisation and globalism; against globalisation, somewhat less.

Nicholas Blanchard writes:


1. US
2. Japan
3. Italy

Although, taken as a whole, the international bond market surpassed the US bond market last year. So using the sort-of-more-appropriate definition of an "asset class", the world's four largest are:

1. International Bonds
2. US Bonds
3. International Equities
4. US Equities

And runner up is real estate.

I'm guessing that this article is what caused Scott to have the "third largest" statistic on his mind:

Here is a breakdown of international asset classes from Vanguard:

Scott Sumner writes:

Bill, Japanese government bonds.

Bacon, Which other ones did you have in mind?

Lorenzo, Good point. Internationalization may make sense in a few areas (mutual defense, global warming) but not in money, not in fiscal policy, and not in (most) economic regulation.

Nicholas Weininger writes:

Re "Italian government bonds are the third largest asset class on planet Earth." Citation? That'd be an interesting list, especially if it included relative magnitudes.

Scott Sumner writes:

Nicholas, I've read that statistic a few times, but the only source I could come up with right now is:

Another source (Quandl) gave some numbers that suggested Italy's government debt it just slightly larger than France and Germany's.

Kevin Dick writes:

I don't think you're using "asset class" the same way I'm used to.

In the wealth management/endowment/asset allocation world, one usually talks about asset classes such as US public equities and US corporate bonds being at the same level of abstraction as US Treasuries (and presumably the Italian equivalent)

The NYSE has an aggregate marcap of roughly $20T. NASDAQ is $6.8T. So the US public equities market is over $25T. Together, Shanghai, Hong Kong, and Shenzen exchanges are almost $10T. The LSE is roughly $6.2T and the Japan Exchange Group is roughly $4.5T. Euronext is $3.3T.

The US corporate bond asset class is roughly $8.4T. US mortgage related bonds are roughly $8.9T.

Italian government debt appears to be 2.3T Euros. So maybe it's in the top 10, but just barely.

Scott Sumner writes:

Thanks Nicholas.

Kevin, I mean in the sense of US Gov. bonds, GE bonds, California bonds, Mexican gov. bonds, Apple stock, that sort of class of assets.

Kevin Dick writes:

Ahh. Typically, that's not how people in my world categorize them. You would compare Apple stock to a particular issue of Italian bonds, e.g., 2010 10-year bonds.

If you aggregate the leaf level securities differently, it distorts your allocation decisions.

Thaomas writes:

I agree that the euro was a huge mistake, but it was anything but a technocratic one. It was political. Economist warned that Europe was not an optimal currency area. What economists did not realize and which made the euro much worse than technocrats would have imagined was that 1) investors would mistake the reduction in currency risk for a reduction in country risk and 2) that the ECB would fail to maintain inflation at its supposed target level.

Rajat writes:

The Economist seems to disagree.

Although, I can't quite make out whether they think Euro exit is more likely with a yes or a no vote.

Scott Sumner writes:

Rajat, I saw that too, but I didn't find their argument to be very compelling.

Olivier writes:

The Italy referendum is an internal affair, not an EU-related referendum like Brexit was. People expect it will be "no", and this will damage the current PM's plans to reorganize some of Italy's internal politics. The government may resign, and new elections may happen in Italy, that's all. If the EU were in danger every time an Italian government fell over some internal issue, it would have collapsed in 1958 already (one year after the Treaty of Rome).

The elections of France and Germany in 2017 are much more important.

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