Rearranging the deck chairs on the Eurozone

Rearranging the deck chairs on the Eurozone

Don’t believe the market. We haven’t even made it to the eye of Europe’s storm.

The EU and Italian government had a standoff in September and October.

It sunk stock markets around the world about 10%.

The same budget battle is about to rear its ugly head once more.

The Italians have five days to send a revised budget to Brussels for approval.

The rhetoric in the lead-up to the big day is great fun to follow:

The Express:

We’ll KNEEL no longer!” Italy-EU clash BOILS over as Salvini dismisses “THREAT” letter.

No, the budget proposal coming to Parliament is a policy which allows Italy to grow and helps Italians.

Nothing and nobody, no big or small letter will make us backtrack. Italy will no longer be a slave and will no longer kneel down.’

And:

I don’t have to make concessions” Italian PM’s stern warning to EU in budget row CLASH.

Politico:

Commission President Jean-Claude Juncker said Tuesday in an interview with the Italian news agency ANSA that there would be a “violent reaction” from other Eurozone countries if Brussels were to accept Rome’s proposals.

The Financial Times:

If the recipe works here, it will be said at a European level: We should apply the recipe of Italy to all other countries,” Mr Di Maio said in an interview with the Financial Times.

We will tattoo ourselves to explain to the investment community that we do not want to leave the eurozone,” he said.

This sort of bluster is normal in Italian politics.

Not that the budget figures are any different. They’re full of showmanship instead of maths.

The EU and Italian government can’t even agree on where Italy’s proposed spending would actually leave the country.

The EU is convinced the proposed budget will lead to a breach of EU deficit rules by 2020. Not to mention reneging on the existing agreement to bring down the deficit in the first place.

The Italian government claims their spending boost will trigger extraordinary economic growth, reducing their deficit over time.

You can see how the two diverge in this chart, discovered by Zerohedge.

Source: Zerohedge

The trouble with all this is what the EU will do if Italy doesn’t comply with EU rules.

If the EU doesn’t get a revised budget in five days, they’re likely to act.

Next on the agenda would be a fine and sanctions. There’s quite a list of specific options for the EU to consider. Each of them is hilarious given they only intensify Italy’s specific problems.

A fine of between 0.2% and 0.5% of GDP would only make the Italian government’s financial position worse.

Withholding EU funds that flow into Italy is a political no-no. Italy’s leaders blamed the Genoa bridge collapse on the lack of EU infrastructure funding.

If the EU stops sending money, it would leave populist parties with even bigger shares of the vote.

If the ECB plays hardball with the Italian banking system or sovereign bond market, it would force Italy to refinance debt at impossible interest rates.

The only question then would be whether Italy leaves the euro before or after a major financial crisis begins.

One your Super balance got a taste of in October.

If you ask me, fining Italy based on an economic forecast is bonkers.

The fact that the EU doesn’t wait for the results of policies before declaring their judgement tells you everything about the EU’s true nature.

The lifeboats are being lowered half-empty

While the EU faces off with Italy, the EU’s fiscally sensible nations are making for the lifeboats.

A group of ten Nordic, Baltic and hanger-on nations, calling themselves the New Hanseatic League, are busy trying to reform the EU’s bailout mechanisms.

The proposal released by the New Hanseatic League’s finance ministers is to beef up the European Stability Mechanism.

This is Europe’s version of the IMF.

But for now, it’s just a bailout fund for European governments.

The fiscally responsible nations want to turn the ESM into an overseer of government budgets. With a big stick instead of just an indefinite supply of carrots.

Several powers would be transferred to the ESM under the proposal. Powers the IMF and the EU Commission currently hold.

More importantly, the finance ministers want the ESM to be able to impose losses on sovereign bondholders before it provides a bailout.

TV presenters call this a haircut.

It’s more of a decapitation!

Why? Because EU banks rely on sovereign debt being ‘risk-free’, as they are designated by EU law.

Even small losses could be disastrous for European banks.

The idea behind the Hanseatic initiative is to ring-fence bailout decisions from political influence.

If the European Commission is making financial assessments and bailout decisions, political influence will play a part in those decisions.

A new bureaucracy is less likely to bow to political pressure.

The counterattack comes in an attempt by populist European parties to take control of the EU. In May, Europe will hold its European Parliament elections.

If the populists can influence EU policy from within, they might find themselves with less of an opponent over budgets and bailouts.

But I’m not sure we’ll get that far.

While Italy, the EU and the New Hanseatic League posture and prognosticate about firm possibilities of definite future maybes, reality is changing beneath them.

The Italian economy stopped growing in the third quarter of 2018. And the outlook is even worse.

The UK’s Telegraph newspaper summarised the most recent data out of Italy:

Italy’s PMI fell to 49.3, its worst result in almost five years and down sharply from 52.4 in September. This indicates the economy is into contractionary territory.

According to Citi economist Guillaume Menuet, Italy is “flirting with recession”.

Mr Menuet estimates that this level of PMI is consistent with a 0.2pc fall in GDP, down from flat GDP in the third quarter.

Slowing external demand for manufacturers and increasing uncertainty on the domestic economic outlook and economic policies are clearly weighing on Italian growth,” he said.

It clearly makes the government’s budget projections even less attainable.”

Overnight, Italy’s banks struggled in the stock market and Italian bonds fell too.

Understanding the link between financial markets and politics is especially tough when it comes to Italy.

Obviously, economics is the crucial factor in many ways. Italy must finance its deficits somehow. People must lend it money. And all that comes down to maths.

But Italy’s implicit European rescue is a political decision. Italy’s budget and any sanctions from the EU are political decisions. Leaving the euro is a political decision.

The economic pressure is growing. The incentive for Italy to dump the euro grows with it.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia