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Saturday, June 18, 2011

Well, The Polenta Pot Is Simmering

Moody's warned of a possible downgrade of Italy's credit rating by the fall. S&P has a negative outlook on it.

This is not particularly surprising, because Italy's government debt is supposed to end the year well over 110% of GDP, and the math is intimidating indeed. If interest rates rise, which they are expected to do when ECB raises, Italy takes a hit. Italy has had trouble for years with bond yields, and one of its current problems is that it has been tightly managing the situation for years, so it becomes incrementally more difficult to squeeze margin out.

Italy is currently running a primary surplus, but for all of that, trying to pay down debt over 100% of GDP requires that your economy grow more nominally each year than the average interest rate on all that debt. Italy is and has been in a low-growth mode. Since Italy is on the Euro it cannot inflate its currency to achieve higher nominal growth.

The CW is that Moody's action will force Germany to ante up to continue infusions to prevent Greek default. Maybe so, but in the end, Italy will have to move off the Euro or Germany will have to accept a higher level of Euro inflation.

Draghi, the next ECB head, is from Italy's finance sector, and I have to believe the remarkable unity shown over his selection has to do with keeping Italy hard at the grindstone for a while longer. But for how long?

This blog accurately defines the situation as I see it. Mathematically, it is just about impossible for Italy ever to shrink its Debt/GDP ratio, and this despite running a primary surplus for so many years!

Running a primary surplus means that Italy's government spending on everything except for interest is below government revenues. Italy is the classic example of why countries are in danger of default on their sovereign debt once the ratio goes above 90%:
According to OECD data, while Italy ran cyclically adjusted primary deficits (that is deficits before including interest payments) every year between 1970 and 1991, the country has run cyclically adjusted primary surplus every year since 1992 - even during the depths of the recent crisis. Thus Italy’s cyclically adjusted primary balance (as a % of GDP) has been in better shape than the balance of many of the largest developed economies. Notwithstanding this, the weight of debt as a % of GDP has continued to rise. So, while Eurostat recently confirmed that the Italian 2010 public deficit was 4.6% of GDP, and 40 basis points below the Government target,the debt to GDP ratio was revised up to 119% (in this case higher than the Government’s target number). What makes the difference is the impact of history and the weight of the accumulated debt, since interest needs to be paid on the debt.
Italy could resume stronger growth if it didn't have to service all that debt, but the effort of running a primary surplus drains the economy and makes it impossible to grow out of that debt. When Italy defaults will depend on how high the rates on that debt are. Italy has been staggering along by booking nominal GDP growth of around 4%, at the cost of higher internal inflation. This has really hurt the middle class and is cutting domestic consumption, so Italy has to depend on exports for growth. This, of course, makes it vulnerable to downturns in the economy of the west.

The thing is, Italy's economy is quite viable given what they have been doing if they just go to the lira, or if they restructure their debt. To keep Italy going along, ECB probably needs to hold rates down, but I don't think Germany is willing to accept the inflation levels Italy needs.

Given this situation, does it really make sense for Germany to throw a bunch more money into Greece? When the effort needed to fund Greece gets to the point at which Germany finally has to throw real money in the pot, then Germany's going to bag on the deal.

There are other nails in Italy's economic coffin. Italy's demographics stink. The median age is around 45. Also, Italy's economy is acutely dependent on energy imports, so the higher fuel costs in this cycle are hurting its economy badly. Italy held a recent referendum on the French way out, i.e., nuclear power, but a resounding "no" means that option is gone.

Oddly enough, it is Greece that doesn't want to go off the Euro, because Greece cannot cover its primary deficit. When you are already running a primary surplus, you have the fiscal discipline in place to be able to default or devalue a currency without too much current pain and with the definite prospect of future gain.

The only way I can see of saving the Euro's current configuration is for the various governments to get private holders to throw sovereign debt into a fund, and then for the various governments to pool those funds and do cross-sovereign debt writeoffs. Admittedly, someone's "assets" get eliminated, but when enough panic develops private investors might be willing to do it.

In the US, of course, the "assets" that will get thrown in the pot are the Social Security and Medicare trust funds. That's been clear for over a decade.

Note: The CW that the Italian rating comment would force an agreement on Greek debt appears to have been unfounded.

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