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Generational Dynamics Web Log for 24-Oct-2018
24-Oct-18 World View -- European Commission rebukes Italy, after blatant budget rules violation

Web Log - October, 2018

24-Oct-18 World View -- European Commission rebukes Italy, after blatant budget rules violation

Greece's elderly still face possible pension cuts in January

by John J. Xenakis

This morning's key headlines from

European Commission rebukes Italy, after blatant budget rules violation

A horse-drawn carriage passes a branch of Banca Monte dei Paschi bank in Rome.
A horse-drawn carriage passes a branch of Banca Monte dei Paschi bank in Rome.

It's like writing a letter to your bank and saying that you'll be making only half your mortgage payments for three years, and that they should understand because you need the money. Your bank would have to reject your statement forcefully.

On Monday, Italy's Economy Minister Giovanni Tria sent a letter to the European Commission (EC), clearly saying that Italy intended to violate EC budget rules from 2019-22:

"As regards the path of the structural balance, the Italian Government is aware of having chosen a budgetary policy approach that is not in line with the application rules of the Stability and Growth Pact. It was a difficult but necessary decision ally of the persistent delay in recovering pre-crisis GDP levels and the dramatic economic conditions in which the most disadvantaged strata of the Italian society are found. The Government also intends to implement the qualifying parts of the economic and social program on which it has obtained the confidence of the Italian Parliament. The Update Note of the Economic and Financial Document, and the attached Parliament Report, clarify that the Government plans to deviate from the structural adjustment decrease in 2019 but does not intend to further expand the structural deficit in the following two years and undertakes to return the structural balance towards the medium-term objective starting from 2022. If it were to return to pre-crisis level before the forecast, the Government intends to anticipate the return path."

This is a direct, and possibly unprecedented challenge by an EU member state to the European Commission, and it required an unprecedented response. The EC firmly rejected Italy's proposed 2019 budget, and demanded a compliant budget within three weeks.

Readers may recall that when Italy held nationwide elections in March, the elections failed to produce a majority party. Two particularly bitter rivals were the left-wing Five Star Movement (M5S) that got 32% of the vote, and the right-wing La Lega (The League) that got 17% of the vote.

Incredibly, these two parties got together and formed a governing coalition. They're far apart on many issues, but they do share similar attitudes on three issues: a nationalistic anti-euro attitude, a xenophobic anti-immigrant attitude, and a complete lack of fiscal discipline. Much to everyone's surprise, they formed a governing coalition based on these three principles.

This new governing coalition announced a list of policy proposals, including a completely delusional list of economic proposals.

Italian debt stands at around €2.3 trillion ($2.7 trillion), or 133% of gross domestic product (GDP), the worst in Europe. The new government does have a way of reducing the debt: spend a lot more money, and drastically reduce taxes. (As I wrote at the time, I wish I could tell you that this is a joke, but it isn't.)

Specifically, the government would like to do the following right away:

So now the time has come for Italy to submit a 2019 budget to the EC to fulfill these delusional campaign promises, and the budget far exceeds EC rules, as well as Italy's previous commitment to fiscal discipline.

What we can say at this point with certainty is that, with the EU already buried in problems from Brexit and immigrants, Italy's budget is sure to create an additional huge new fracas.

It seems pretty clear that Italy's government is out of control fiscally, and that they will be unable to stop themselves from going into more and more debt. But as the saying goes: If something can't go on forever, then it won't.

According to an analysis by Silvia Ardagna of Goldman Sachs, Italy will not become fiscally responsible until some event forces them to be:

"Financial market participants understand there is value in correctly pricing not just the 'end game,' but also the path to that 'end game' and the risks around it.

From this perspective, our view is that market tensions would need to intensify in order to exert sufficient pressure on the Italian political system to trigger a change in the policy path and the political rhetoric around it.

On that basis — and even if Italy does ultimately remain part of the Euro area — the market situation may need to get worse before it gets better."

Some people are speculating that the event will be "Italexit," with Italy leaving the euro currency and possibly the European Union. However, prime minister Giuseppe Conte said, "I can assure that this executive will not accompany this country, Italy, out of Europe. We feel very comfortable, we feel at home in Europe and we think that the euro is our currency and will be our currency, the currency of my kid, he’s 11 years old, and the currency of my grandchildren."

Commissioner Pierre Moscovici said that "this is an unprecedented situation, and the decision should not be surprising to anyone as the Italian government’s draft budget represents a clear and intentional deviation from the commitments made by Italy last July." Italy's Economic Ministry (PDF) and European Commission and Business Insider and Politico (EU)

Greece's elderly still face possible pension cuts in January

Greece's elderly may not face pension cuts in January after all. The planned pension cuts are part of the austerity program that the EU and the ECB imposed on Greece in return for years of bailouts to prevent the country from becoming totally bankrupt. The pension cuts are necessary to increase the sustainability of Greece's social security system, but apparently most members of the European Commission are willing to put this measure on hold. The final decision on whether to cancel the pension cuts will be made on December 3, but in fact the pension cuts may be made anyway, since Germany opposes canceling them.

I tell this little story to remind readers that even though Greece's financial crisis has been out of the news for a while, it has not been resolved, and there could be a renewal of the crisis at any time.

Greece had to be bailed out in 2010 because the country was essentially bankrupt. Greece was borrowing and spending way beyond its capability to repay throughout the 2000s decade. According to one analyst,

"The history of [Greece's National Statistical Service (NSSG)] reveals that its chief officer (general secretary) was replaced whenever a new party was elected to power. The main objective behind this practice was to control the flow of information; in this respect, the personal or political allegiance of the chief officer was the most crucial factor for the appointment."

We can also say with certainty that if Italy goes on the spending binge, the country will be deep trouble. I don't know why it's so hard for people to understand that it's fun to borrow and spend money, but it's extremely painful when you have to pay it back.

In order to fund its spending binge, Italy will have to borrow money, and Italy will do that by selling government bonds. Moody's last week downgraded Italy's bond rating to Baa3, which is the lowest possible rating that they can have without becoming "junk bonds." In fact, a lot of people breathed a sigh of relief because the downgrade was anticipated, and it was feared that it would be to junk status.

Each time a bond's rating goes down, the value of the bond goes down, and the yield goes up. The yield is the interest rate that the government has to pay to investors who buy the bonds. So during Greece's financial crisis, the yield on Greek bonds went to 5%, to 7%, to 20% to 30% to 40%, and even more. Holders of Greek bonds eventually had to take a 75% "haircut" -- which means that they lost 75% of their entire investments.

This hasn't happened to Italy yet. Italy's ten-year bond yields have gone from 2% at the beginning of the year to about 3.5% recently. If Italy's spending binge continues, then the yields will increase to 5%, 7%, 10%, and so forth, and Italy's debt will become unsustainable.

Even worse, many other banks in Europe have purchased Italian bonds. About 20% of Italy's government bonds are held in other eurozone countries. If yields go up and values go down, then these banks will also be in trouble. That's called "contagion," Dear Reader, and the fear of contagion will cause the European Commission to be very critical of Italy's 2019 budget.

"It is tempting to try to cure debt with more debt, but at some point the debt [becomes] too heavy and at the end of the day, you end up having no freedom at all," Valdis Dombrovskis, vice president of the European Commission, said during a press conference on Tuesday. Kathimerini (Athens) and Kathimerini and CNN and CNBC

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(Comments: For reader comments, questions and discussion, see the 24-Oct-18 World View -- European Commission rebukes Italy, after blatant budget rules violation thread of the Generational Dynamics forum. Comments may be posted anonymously.) (24-Oct-2018) Permanent Link
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