Italy ignores the rules
Last weekend, we looked into whether debt financed prosperity is real. On Thursday, the Australian Financial Review reported it isn’t:
‘PIMCO warns that rising mortgage costs will increase mortgage payments from 38 per cent of pre-tax income to close to 48 per cent, near its worst level over the past two decades.’
Interest rate shocks are a shocker. Not only can debt steal your wealth, it can steal your income, too. I hope they warned housing ladder-climbers about this.
Further AFR articles have the headlines ‘Developers squeal over apartment price slump’ and ‘6700 apartment projects blacklisted for loans’.
Interest rates are in an upcycle. Upcycles always end in a crash and a crisis. The only question is who falls victim first. Then the global contagion is on. And good luck to Aussie banks and property owners this time around.
But who will it be? Which debtor is big enough to cause a global crisis this time?
My bet is still on Italy. And starting Friday, things began to hit the fan.
Italy’s finance minister was supposed to release budget projections. He’d promised they’d be in line with EU demands.
Instead, the leaders of the political parties in government released their own budget forecasts. And those left EU limits looking like roadkill. My friend Luca Bertoletti summed up the numbers:
The commitments of the previous Italian government foresaw a deficit of 1.6% in 2018, of 0.8% in 2019, of 0% in 2020, and a surplus of 0.2% in 2021.
The difference to the new proposal, which promises a deficit of 2.4% each year, is thus 0.6% in 2019, 2.4% in 2020, and 2.6% in 2021.
The Italian markets tanked. Bonds and banks were especially battered. The Aussie dollar took a hit, too.
But this was only the budget projection – the size of the deficit Italy is expecting to budget for when it details spending. It merely sets the stage for an epic budget battle later this month with the EU when the actual spending is laid out.
By the way, the budget forecasts are a joke when it comes to the economics. They’re projecting decent GDP growth and restrained spending in the future. Neither is likely.
Italy ignores the rules
In 2014, the IMF forecast for Italy’s debt-to-GDP to fall each year for a total drop of 15% by next year. So far, it’s been stuck above 131% ever since instead.
The real story is about the politics. Italy’s politicians are signalling they don’t care about EU rules. And that is what matters. Because it makes a default and departure from the euro a lot more plausible. Credit default swaps are pricing in a 21% chance of an Italian default within the next five years, up from 7.5% in April.
Greece has shown that some countries are willing to be politically humiliated and economically immolated by the EU and IMF. The IMF even had to apologise to Greece.
The question is whether Italy will go down like Greece. Or put up a fight.
EU Commission President Juncker didn’t shy away from the comparison:
Italy is distancing itself from the budgetary targets we have jointly agreed at EU level. I would not wish that, after having really been able to cope with the Greek crisis, we’ll end up in the same crisis in Italy.
The Italian response was telling. Deputy Prime Minister Salvini threatened to sue the EU for market manipulation after Italian bond yields spiked on Juncker’s comments. And then, Salvini hit European Commission President where it hurts by saying he’d ‘only talk to sober people’.
The Commission President maintains he has sciatica, not a drinking problem.
Fellow Italian Deputy Prime Minister Luigi Di Maio said, ‘We are not turning back from that 2.4% target, that has to be clear. We will not backtrack by a millimetre.’
Days later, he did backtrack, according to newspaper reports. The deficit in later years may be lowered marginally. But like I said, by then economic growth will lag enough to make the promises irrelevant.
I’ve been warning about all this since April. But today, I want to focus on a particular aspect of it.
The EU is losing it across the board
Italy’s budget deficit is nowhere near out of line with historical budgets. America’s deficits make Italy look boring. And other EU countries broke the rules endlessly in the past.
What’s Europe’s endgame? Why is it applying artificial pressure on Italy?
Why did European Commission President Juncker say, ‘If Italy wants further special treatment, that would mean the end of the euro. So you have to be very strict.’
The answer is Brexit.
The Europeans see both Brexit and the Italian budget as an existential threat. The Financial Times provides the corresponding quote to Juncker’s above:
France’s finance minister has insisted that Theresa May’s blueprint for the UK’s future relationship with the EU is unacceptable because it undermines a central tenet of the bloc and would spell ‘the end of Europe’.
Again, this is nonsense.
Norway, Switzerland, Gibraltar, Denmark and Britain all operate under unique arrangements with the EU that ‘undermine a central tenet of the bloc’ in some way. The EU’s history is a long line of deals that make joining the EU acceptable to individual nations.
Is the experiment over?
For years, the EU said Britain could have a trade deal if it left the EU. But suddenly, such a deal with Britain is not possible.
The EU senses that its existence and the existence of its most important achievement – the euro – are under threat.
All it takes is a successful Brexit or Italian defiance and the political momentum will swing against the project.
Every nation from Hungary to Greece is watching Brexit and Italy closely to find out if they want to queue up to be next.
That is why the EU is suddenly playing hardball on both fronts.
Who are you backing?
Until next time,