Will Italy Sink Europe?
Jim O'Neill
Italy's coalition government has been generating headlines with its pursuit of populist economic policies that threaten to leave eurozone fiscal rules in tatters. But before EU authorities respond, they should bear in mind that if Italy does not achieve stronger GDP growth, political conditions there could deteriorate further.
LONDON – Despite political turmoil and emerging risks at the global level, the eurozone has had two years of strong economic growth, at least by its own historically disappointing standards – and even with the United Kingdom lurching toward withdrawal from the European Union. But with the emergence of a populist government in Italy this year, it is no longer safe to assume that the eurozone’s worst days are behind it.
Italy was the first country that I studied when I entered the financial world back in 1982, so I have a special affection for it. I was working for a very large American bank at the time, and I can still remember joining frequent transatlantic conference calls to discuss Italy’s debt-to-GDP ratio. The question on everyone’s mind was when the country would default; but it never did. Instead, Italy muddled through, and has continued to do so ever since. Still, now that the Italian government seems poised for a standoff with the EU, it would not be surprising if worries about a default were to re-emerge.
As my experience more than 30 years ago shows, Italy’s economic problems far predate its adoption of the euro. It has long had poor productivity by European standards, and that translated into relatively low trend growth in the pre-euro decades. At the same time, occasional spurts of faster growth regularly sowed the seeds for various crises, often resulting in devaluations of the Italian currency, the lira.
Of course, there are some who now yearn for the days when the lira could be weakened to restore growth. That is no longer an option under the single currency. But what the pre-euro romanticists overlook is that euro membership has given Italy low inflation, and thus lower interest rates. Moreover, there is reason to think that lira devaluations did more harm than good. Even if they offered an occasional competitive boost, they stood in for tougher structural reforms that would have increased productivity over the long term.
There are also some who believe that the eurozone’s fiscal and monetary framework locks Italy into weak nominal GDP growth, possibly too-low inflation, and high debt. Yet before the new government took office, Italy’s cyclically adjusted fiscal deficit – as opposed to its underlying debt position – was often rather restrained compared to the rest of the eurozone, as well as the other members of the G7 (Canada, France, Germany, Japan, the United Kingdom, and the United States).
Still, the mainstream political parties that governed Italy until this year did not deliver the nominal GDP growth that the country needs. As a result, Italians elected an unconventional coalition whose program combines the policies of the populist left with those of the populist right. While the League party promises to cut taxes, the Five Star Movement (M5S) is pursuing a form of basic income.
But what Italy needs is a broad structural reform program to improve productivity. That is the only way to achieve a higher long-term growth rate, given the country’s demographics. In addition to enacting policies to boost the labor-force participation rate among women, Italy must provide more attractive opportunities for its young people.
For its part, the EU should do more to help Italy take the tough steps it needs. The European Commission, the European Central Bank, and the German government have erred in insisting on rigid enforcement of the EU Stability and Growth Pact, particularly the 3%-of-GDP cap on fiscal deficits. Although some countries have been allowed to breach the deficit cap during challenging times, Italy is almost never afforded much accommodation, owing to its high debt levels. Yet as the experience of Belgium and Japan shows, high government debt can be reduced only through sustained economic growth.
Complicating matters further, some reforms to boost long-term productivity can actually reduce growth in the short term. Thus, any government enacting such measures will need to have the option of pursuing counter-cyclical stimulus.
Another problem concerns monetary policy. The ECB could stand to be more broad-minded in how it pursues its inflation target of just under 2%. That target, along with Germany’s own 2% target, leaves Italy locked into a state of low inflation, even when it could benefit from more monetary-policy stimulus.
Under these conditions, the EU authorities would do well not to oppose the current Italian government’s plans too aggressively. If mainstream liberals are worried about the implications of a democratically elected populist government, then they should worry even more about what could come next if economic circumstances worsen. At this stage, Italy needs stronger nominal GDP growth – plain and simple.
Some will say that it was a mistake to have allowed Italy into the eurozone in the first place, and that an optimal currency zone should have been more discriminating in its membership. But the German and French business communities insisted that the monetary union must include some of Italy’s more competitive companies. And once Italy was considered eligible, so, too, were many other countries.
At the end of the day, those with the power to set and enforce EU fiscal and monetary rules know full well that the eurozone could not survive a Greek-style crisis in Italy. It is their responsibility in the months ahead to make sure it doesn’t come to that.
Jim O'Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister, is Chairman of Chatham House.
WILL ITALY SINK EUROPE? / PROJECT SYNDICATE
DEFINING XI´S "CHINESE DREAM" / GEOPOLITICAL FUTURES
Defining Xi’s ‘Chinese Dream’
What does the Chinese leader mean when he talks about a national renewal?
By Jacob L. Shapiro
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THE WEAPONISATION OF THE DOLLAR RISKS REBOUNDING ON THE U.S. / THE FINANCIAL TIMES
The weaponisation of the dollar risks rebounding on the US
One consequence of the America First policies will be to create a bipolar financial world
Henny Sender
A glance at the foreign-exchange markets suggests that the US dollar looks as powerful and dominant as ever.
However, taking a much longer-term view suggests that this impregnable position — and the economic heft that comes with it — will come under assault.
One consequence of the America First policies of US President Donald Trump will be to create a bipolar financial world, with China at one end and the US at the other. That will mean smaller financial flows between the two, and a much more robust effort from Beijing to eventually challenge the dollar’s status as the world’s reserve currency. That, in turn, potentially has implications for everything from the status of US Treasury securities as the safest assets in the world to how oil is priced.
“The Trump administration’s “America First” policy will encourage a long-term move away from the US dollar,” according to Christopher Wood of CLSA, the arm of Beijing-based Citic Securities, pointing to “the growing American practice of using the dollar as a weapon via the implementation of sanctions and the like.”
But this more explicit weaponisation of the dollar has not only incurred the wrath of China, it is increasingly alienating government officials and politicians in Europe, the Middle East and Asia as well as infuriating some bank executives. Some of the latter believe the US has been able to impose exorbitant fines for violating US laws because authorities can threaten to lock them out of the dollar-driven financial system.
At the Milken Institute’s Asia Summit last month, former French prime minister François Fillon spoke of the need for Europe to push its currency as an alternative to the dollar in an effort to bolster European sovereignty. A world in which the dollar is the dominant reserve currency means Washington can chose to dictate policy to Europe as it has, for example, on the question of doing business in Iran. Europe has no choice but to go along or risk becoming the object of sanctions itself. Yet is it wishful thinking to believe the euro, which according to recent data from the International Monetary Fund has about a 20 per cent share of central bank reserves, can play anything but a minor role. Instead Europe, like the rest of Asia, will have to decide where its future lies — with China or a shrill but shrinking US.
When China began trading renminbi-denominated crude oil futures out of Shanghai in March, it was a signal of Beijing’s determination to eventually forge a world in which not everything is traded in dollars. At major Chinese conferences this year, government officials and the heads of some of the most important state-owned enterprises noted that domestic demand for commodities, including oil and natural gas, is so great that it makes far more sense for them to be priced in renminbi. China already uses its own currency to pay for Iranian and Russian oil. Meanwhile, transactions in the Shanghai market are up dramatically.
Monthly transaction volumes went from 623m barrels in April — the first full month of trading, to 3.4bn barrels in August to 2.7bn barrels in September, according to CLSA, citing data from the Shanghai International Energy Exchange.
Beijing’s ambitions to challenge the status of the dollar can be seen in other ways. For example, the People’s Bank of China now has foreign-exchange swap lines with at least three dozen countries. That is in contrast to the much smaller number the US Federal Reserve has.
While few have brought it up even as tensions between Beijing and Washington escalate, the inflow of Chinese money is important for the US government bond market, giving the mainland leverage if it chooses to use it. China and Japan are the two largest foreign holders of Treasuries, whose issuance is increasing as the fiscal stimulus swells the US budget deficit.
Without demand from China, rates in the US could go even higher. It may not be in the mainland government’s narrow financial interest to do so but this is a time when politics is clearly in ascendancy.
At the same time, the renminbi can only become a reserve currency if it can offer the world attractive RMB-denominated investments. It is thus unsurprising that China is increasingly opening up its own government bond market to foreign investment in the hope that its increasingly liquid market can one day become an attractive alternative to the US market.
For investors who are judged on their returns in dollars — no matter where in the world they are based (and that huge group includes many sovereign wealth funds) — a world in which the renminbi becomes more important will add a layer of complexity.
When elephants joust, the mice get trampled, the saying goes. In this case, investors are the mice that may get caught in the unpredictable fallout of the tensions between the two jousting trans-Pacific powers.
THE EU GOES TO BATTLE OVER ITALY´S BUDGET / GEOPOLITICAL FUTURES
The EU Goes to Battle Over Italy’s Budget
Brussels can’t afford to look weak on its fiscal rules but lacks the means to enforce them. Its solution? Market pressure.
By Ryan Bridges
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FISCAL DISASTER IN THE TIME OF POPULISM / SAFE HAVEN
Fiscal Disaster In The Time of Populism
By Josh Owens
This rise of populism is creating murky financial waters for both emerging and developed markets.
Case in point, Italy, where the new populist government is willing to give the people what they want: A break from austerity. But it’s a dangerous move that represents “irresponsible fiscal policy”, Michael Hasenstab, chief investment officer at Templeton Global Macro, told CNBC.
Hasenstab describes populist-led fiscal policy as “probably one of the most important political variables we have to look at” when considering investments.
Italy’s new coalition government is anti-establishment—and anti-austerity, and it’s promising all sorts of things that the country can’t afford, including tax cuts, basic monthly wage guarantees and more.
Italy’s populist leaders don’t have enough wiggle room to take on more debt, and they’ll find that out when Italian bond yields rise further. From an investors’ perspective, this is what will bring down Rome.
Italy’s national debt is at 132 percent of GDP and it’s got one of the slowest growth rates in the euro zone, with unemployment at 11.2 percent. And the European Union has mandated austerity since the beginning of the decade. The new government doesn’t feel like bowing to the EU’s monetary guidance, and it’s rebellion is increasingly popular with a public that has grown tired of living under austerity.

(Click to enlarge)
Italy’s 2.3-trllion euro national debt is worse that Greece. The EU says Italy is courting disaster, facing a massive debt restructuring challenge. And it’s not just a threat to Italy, but to the euro itself.
Still, Italy’s populist government is bent on fighting the EU. As recently as last week, it said it sought to triple the 2019 budget deficit plan of the preceding government.
Italy’s financial irresponsibility is sparking cries of everything from “complete insanity” to “sleepwalking into a next crisis”, Reuters reports, citing senior EU officials.
“When Tria talked about planning a deficit of 2.4 percent for the next three years in the Eurogroup, jaws dropped everywhere,” Reuters quoted one senior euro zone official as saying.
“The mood was that this was really a terrible signal.”
And while Italy may be the worst-case scenario, it’s not the only venue where populism is threatening fiscal policy.
Germany is also on Hasenstab’s red flag radar because the far-right is increasingly posing a challenge to the mainstream government. It’s more than just a fleeting concern, too. A new study indicates that populist attitudes are on the rise in Germany—and its coming from the political center.
According to a Bertelsmann Foundation study cited by DW, one in three voters now sympathizes with populist policies.
So who’s not on Hasentab’s red-flag watchlist? Oddly enough, India and Indonesia. Both countries have unenviable current account deficits; and both are experiencing currency issues, but Hasentab says that despite all, both are “the type of investment we are looking for”.
In fact, the World Bank this week said that Indonesia’s weak rupiah is actually a source of strength, Bloomberg reports.
“With a flexible exchange rate now, moderate devaluation makes imports more expensive, exports cheaper, and the dollar value of profit transfers lower,” Rodrigo Chaves, World Bank country director for Indonesia and Timor-Leste, said in a statement on Wednesday. “These elements reduce the current-account deficit automatically.”
The Indian rupee, however, hasn’t enjoyed any such statements from the World Bank, and on Wednesday it closed at its weakest level, opening even weaker Thursday, having lost some 15 percent this year already. Some analysts are warning that the rupee could fall as low as 75 per dollar this year, pushed down by trade wars and rising crude prices.
But this isn’t populist-promoted fiscal irresponsibility.
Hasenstab notes that India's current account deficit has been negatively affected by rising oil prices, not fiscal irresponsibility.
"We still have a very long-term positive view for both India and Indonesia. And we talk about a current account deficit, but really, both of those countries have dealt with oil at a higher price," he told CNBC. "Both countries are pursuing some very sound, be it fiscal policy, or in India's case, really revamping the monetary system ... inflation targeting, tax reform."
He might agree with the World Bank’s statement on Indonesia—for India, too. Both countries he describes as a “long-term anchor”.
But hedge funds and other investors love the clarity of political situations, like the clear rise of populism in Italy, because it helps to better pinpoint investments. In this case, the new buzz word for political risk is “populism”, and now we’ve got a list.
Bienvenida
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Friedrich Nietzsche
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
Lao Tse
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
Warren Buffett
No soy alguien que sabe, sino alguien que busca.
FOZ
Only Gold is money. Everything else is debt.
J.P. Morgan
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Proverbio Chino
Quien no lo ha dado todo no ha dado nada.
Helenio Herrera
History repeats itself, first as tragedy, second as farce.
Karl Marx
If you know the other and know yourself, you need not fear the result of a hundred battles.
Sun Tzu
Paulo Coelho

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