Italy’s Swan Dive

This development isn’t a black swan. Rather, it is more like a gray swan. It doesn’t come as a big surprise, yet it wasn’t widely expected either. The question is whether this problem will be contained or whether the latest political mess will trigger the next global financial crisis, which could trigger a global credit crunch and recession. The short answer is that I don’t think it will trigger a global credit crunch and recession.

During the various Greek debt crises that started in 2010, there were similar concerns. Yet the problem was contained as the IMF and EU worked out bailout deals with the Greeks. When the ongoing Greek crisis first started, pessimistic pundits predicted that even if Greece didn’t cause the next global calamity, Italy certainly could do so if push ever came to shove over that country’s messed up financial situation. That didn’t happen because the European Central Bank (ECB) bailed out all the PIIGS by providing ultra-easy monetary policy that allowed these highly indebted “peripheral” Eurozone countries to stay afloat as the ECB purchased their dodgy debts. (The PIIGS are Portugal, Ireland, Italy, Greece, and Spain.) Consider the following implications of the latest development:

(1) ECB stuck in an easing place. I think it’s safe to say that the Italian crisis will force the ECB to postpone any plans for normalizing monetary policy in the near future. After all, it was the bank’s president, Mario Draghi, who famously declared in a 7/26/12 speech: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” That set the stage for a dramatic drop in government bond yields in the Eurozone through mid-2016. The yield spread between Italian and German bonds narrowed significantly, as did the spread between Spanish and German bonds. However, on Monday the former spread jumped sharply. The Spanish-German spread also widened.

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Draghi’s ultra-easing monetary policies included a massive QE program, which increased the ECB’s balance sheet from €2.0 trillion at the end of 2014 to €4.6 trillion in late May, led by purchases of “securities of Euro Area Residents in euro.” In addition, the ECB’s official borrowing rate has been slightly below zero since June 2014.

All that huffing and puffing by Draghi has revived Eurozone lending activity since 2015, but not by a lot. However, the same cannot be said of Italy, where private-sector net lending by MFIs (monetary financial institutions excluding the ECB) has been mostly negative since the second half of 2011, and increasingly so since mid-2017.

(2) TARGET2 divergences widening. The weak link in the Eurozone financial structure may be that despite all of Draghi’s efforts to balance the inherent imbalances among the economies of the region, the imbalances are worsening, according to TARGET2 data. TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the EU. (“TARGET,” or the Trans-European Automated Real-time Gross Settlement Express Transfer System, was replaced in November 2007 by TARGET2.) The data show that the cross-border transactions within the region were relatively well balanced during the second half of 2008 through the end of 2009. But then the Greek crisis hit in 2010 and threatened to spread to the other PIIGS during 2011. As a result, money poured out of Italy and Spain. It went mostly to Germany.

The imbalances diminished significantly following Draghi’s July 2012 speech. But now they are bigger than ever, with surpluses totaling €1.3 trillion during March in Germany, Finland, Luxembourg, and Netherlands. The rest of the Eurozone has a net deficit of €1.0 trillion.

Hans-Werner Sinn, president of the Munich Ifo Institute, first warned about the increasing TARGET2 balances in a 2/21/11 article in Wirtschaftswoche. He drew attention to the enormous increase in TARGET2 claims held by Germany’s Bundesbank, from €5 billion at the end of 2006 to €326 billion at the end of 2010. He also noted that the liabilities of Greece, Ireland, Portugal, and Spain totaled €340 billion at the end of February 2011. He added that in the event that any of these countries should exit the Eurozone and declare insolvency, Germany’s liability would amount to 33% of their unpaid balances. Wikipedia reports that before Sinn made them public, the deficits or surpluses in the Eurozone’s payments system were usually buried in obscure positions of central bank balance sheets.

(3) Good for US bonds and the dollar. The Italian political crisis helps to remind us why the 10-year US Treasury bond yield has continued to trade well below the growth of nominal GDP in the US, despite the deteriorating outlook for the US fiscal deficit. When global investors are spooked and decide that it’s time to move from a risk-on to a risk-off strategy, they tend to buy US Treasury bonds, which means that they also have to buy US dollars to do so. The US Treasury bond yield has clearly been globalized rather than normalized. In normal times, it should be trading around the growth rate of nominal GDP, which is about 4.0%-4.5% currently. Instead, it is back below 3.00% because comparable German and Japanese yields are close to zero.

The trade-weighted dollar has appreciated 5% since February 1. That strength seemed to be fueled by Trump’s protectionist threats. Now the strength is likely to be driven by a weaker euro while we all are waiting to see whether the Italian political upheaval morphs into a more serious economic crisis.

(4) More gradual Fed? The latest FOMC minutes show that several participants of the FOMC are concerned about the flattening of the yield curve. They noted that it’s been a very reliable indicator of recessions when it has inverted in the past. Until recently, the yield curve has flattened as the Fed raised the federal funds rate more than bond yields rose in response to the Fed’s hikes. Now several Fed officials might argue for an even more gradual normalization of US monetary policy if the US bond yield falls in reaction to the Italian crisis.

(5) One more thing. Business Insider reports that “Article 75 of the Italian constitution forbids referendums dealing with international treaties. That means that the country's constitution would need to be changed before a referendum could be held on EU and euro membership. A two-thirds majority in the lower house of Italy's parliament is needed to change the constitution. Such a majority looks highly unlikely right now, even if the Northern League and Five Star Movement increase their vote share in any future election.”