Italian election results expose eurozone inadequacy

Until prosperity is better distributed, Europe will remain vulnerable to upheaval

Martin Wolf

The election results in Italy are a lesson to Europe. Italians were once among the most enthusiastic supporters of the European project. This is true no longer. The combination of economic malaise with political impotence has discredited not only Italy’s political and policymaking elite, but even the country’s engagement with the EU.

This does not mean Italy will leave; the costs would be too great. It means instead that the threat of both friction between Italy and the European establishment and further financial and economic disruption is now far greater.

The election results are quite as shocking as the Brexit referendum and the election of Donald Trump in the US: 55 per cent of the voters chose Eurosceptic and anti-establishment parties.

The Five Star Movement — an amorphous party of protest — gained 32 per cent of the vote and the League — a rightwing nationalist party — gained 18 per cent. The share of the centre-left Democratic party, in which the European establishment had put its trust, tumbled from 41 per cent four years ago to 19 per cent. The share of Silvio Berlusconi’s Forza Italia fell to 14 per cent. The populist revolution devours its parent.

Why are Italian voters so disenchanted? The obvious answers are that economic performance has been so dismal, while established Italian policymakers appear so ineffective. This is certainly not only — probably not even mainly — due to Italy’s participation in the euro. But the eurozone has made things worse. Not least, it offers an external scapegoat, which unscrupulous politicians are happy to exploit. Blaming foreigners is always an attractive strategy. In a failing country with a frustrated population, it is irresistible.

One aspect of the eurozone has been the inadequacy of its overall macroeconomic policy. In January 2018, the consumer price index of the eurozone (excluding erratic items) was 7.2 per cent lower than it would have been had it risen at an annual rate of 1.9 per cent since January 2007 — a rate of inflation that is a reasonable interpretation of the European Central Bank’s objective of “inflation rates below, but close to, 2 per cent over the medium term”.

An alternative assessment of macroeconomic policy is in terms of the growth of nominal gross domestic product. By the third quarter of 2017, eurozone nominal GDP was 11 per cent lower than it would have been had it grown at an annual rate of 3 per cent since early 2007 — a rate that would have been consistent with annual real growth of around 1 per cent and inflation of 2 per cent. Under Mario Draghi, the ECB did act successfully in the end. Yet overall macroeconomic policy has clearly been inadequate. It failed to deliver adequate growth in overall aggregate demand (see charts).

Within this weak macroeconomic environment, huge divergences also opened up among individual member countries. Germany’s nominal GDP rose by 34 per cent between the first quarter of 2007 and the last quarter of 2017 (a compound average annual rate of 2.7 per cent).

Italy’s rose by a mere 9 per cent over the same period (a compound average annual rate of 0.8 per cent).

Not surprisingly, given modest overall growth of nominal GDP, even Germany’s core annual inflation averaged a little over 1 per cent. Such low inflation in the core creditor country made adjustments in competitiveness within the eurozone far more difficult.

If the Italian government had been able to pursue its traditional policy of devaluation and inflation, it could have generated a far stronger rise in nominal GDP. That would surely also have delivered higher levels of real output. Italy’s real GDP in the last quarter of 2017 was, instead, 5 per cent below its level in the first quarter of 2007, while its real GDP per head was still some 9 per cent below the 2007 level a full decade later. No wonder Italians are disillusioned.

No doubt, Italy has huge structural economic problems, which tightly constrain growth, but potential output cannot have fallen this much since 2007. Italy also suffers from chronically deficient demand, a failing that the eurozone, as it is now run, is simply unable to remedy. This is partly because overall demand has been too weak and partly because, within the rules, demand cannot be directed to where it is weakest.

A prolonged recession, with high unemployment and low employment has inescapable political consequences. But the biggest frustration may be that the people Italians vote for have next to no room for manoeuvre. The question has rather been whom to elect (or sometimes not even elect) to carry out the policies decided in Brussels and Berlin.  Why not vote for a clown or a party created by a clown? It might not make much difference to what happens in Italy, but it might at least be more amusing.  Some Italian economists now argue that the country could obtain a degree of macroeconomic policy freedom by issuing what is known as “fiscal money” — a parallel currency that could be used to pay Italian taxes.  

This is technically possible. It would surely create hysteria in northern Europe, since it would eliminate the monetary policy monopoly of the ECB. But the very fact that such a radical idea is being discussed demonstrates the scale of the disenchantment in so large and important a country.

Unless and until the eurozone is able to generate widely-shared prosperity, it remains vulnerable to political upheaval. Weaknesses of the system, plus the impotence of democratic politics at the only level that really counts (the national one) remains a recipe for populism and fragility.

Italy, as many remark, is too big to fail and too big to bail. But its voters have moved from europhilia to scepticism. Like it or not, the risks of further upheaval are big.

Odebrecht strikes again

The short unhappy presidency of Pedro Pablo Kuczynski

After the president’s sudden resignation, the country may calm down for a while

PERU’S president, Pedro Pablo Kuczynski, left office on March 21st much the way he had governed during his 20 months in power. He walked out of the massive doors of the presidential palace and started waving to onlookers before taking a call on his mobile phone and ducking into a car. It was a low-key exit for the former banker, who was elected with one of the slimmest majorities in recent history and had little support in congress or among the 30m Peruvians he governed. Most had little idea how Mr Kuczynski planned to help Peru become a solidly middle-class country with strong institutions, as he had promised. His administration, like his departure, seemed distracted.

What felled him, though, was his connection with Odebrecht, a Brazilian construction firm at the centre of multiple scandals across Latin America. In December congress obtained evidence that Westfield Capital, a company owned by Mr Kuczynski, had worked with Odebrecht while he was finance minister and prime minister in a government that awarded contracts to the company. He had repeatedly denied that he had had any contact with the firm. Congress, in which Mr Kuczynski’s party has just 15 of the 130 seats, started impeachment proceedings.

Mr Kuczynski fought off that assault in December, apparently by striking a cynical deal. Kenji Fujimori, a congressman from the opposition Popular Force party, abstained along with nine others, which scuppered the impeachment. Days later, Mr Kuczynski pardoned Mr Fujimori’s father, Alberto, a former president who was serving a 25-year jail sentence for human-rights violations. The agreement left Mr Kuczynski friendless. He had fought the election as a foe of fujimorismo, against the former president’s daughter (and Kenji’s sister) Keiko, who leads Popular Force. The pardon alienated his anti-Fujimori base without placating Keiko, who still controls the largest faction in congress (and expelled her brother from it).

Calm comes from Canada

Opposition congressmen resumed their attack this month, citing further evidence of questionable dealings with Odebrecht. Wilbert Rozas, from the left-wing Broad Front coalition, said the president “showed zero understanding of the need to separate politics from his business life”. His downfall became inevitable on March 20th, when a video surfaced that showed Kenji Fujimori apparently promising another congressman public-works projects in his constituency in exchange for voting against impeachment. Mr Kuczynski’s allies in congress then abandoned him.

In a seven-minute resignation speech, he blamed the opposition, saying it had undermined him from the day he took office. He accepted no responsibility himself.

With Mr Kuczynski gone, things may calm down. His successor is the vice-president, Martín Vizcarra, who was also serving as ambassador to Canada. As governor of the small southern region of Moquegua, he improved education (pupils in the region get the highest marks in Peru on standardised tests). He also brokered an agreement to develop a big copper mine between Anglo American, a mining company, and nearby communities, no easy task. He will be the first president in decades who has made his career outside the capital, which will appeal to a lot of voters.

Opposition congressmen forced Mr Vizcarra out of his job as transport minister in May as part of their campaign of sabotage against Mr Kuczynski. They are likely to treat Mr Vizcarra more gently now, pundits predict. Few want to face another general election, which could be triggered if the chaos continues.

Mr Vizcarra must show soon that he is different from his ill-fated predecessor. “He will fail quickly if he keeps the same kind of cabinet, with bland ministers who seem more interested in their business deals than governing,” says Eduardo Dargent, a political scientist at the Catholic University in Lima. And he will have to prove that, unlike Mr Kuczynski, he can get things done. “When you ask people what the Kuczynski government did, they stare back at you. They have no response,” says Mr Dargent. An early chance for Mr Vizcarra to shine will come on April 13th-14th, when Peru is due to host a regional summit. Donald Trump says he will attend.

The Odebrecht scandal will test Peruvians’ faith in politicians and institutions. The company’s former director in Peru testified in February that it financed campaigns for the last four presidents, including Mr Kuczynski. Mr Vizcarra must ensure that investigations proceed unimpeded, however painful the results.

Don’t Mistake Market Calm for Being Out of the Woods

Investors should search the past for lessons about where we are in the market cycle. 2005 was an instructive momento 
By Richard Barley

Change from a day earlier in S&P 500 stock index

Is the fuss all over? February’s sharp fall in stocks has faded, with the S&P 500 only 3% below its January peak and up 4% for the year. The rise in Treasury yields has paused and corporate-bond spreads are still tight.

But now isn’t the time to get comfortable with the apparent calm.

Assets on central bank balance sheets
Source: Citigroup

The underlying economic picture in March is muddier than in January. Some survey data, like purchasing-managers indexes, suggest that growth may have peaked, while inflation is likely to pick up. Sure, last week’s U.S. jobs data pointed to continued expansion, but central banks aren’t backing down from reducing stimulus. And for those who believe the flow of central bank asset purchases are what matters for markets, rather than the vast stock accumulated, then the period ahead looks troubling. That flow is diminishing.

Even the apparent lack of spillover from the implosion of stock-market volatility products might not be that reassuring. Investors elsewhere, not directly affected by the financial fallout, may be underplaying the significance of this event.

A worker labors at a construction site in Washington, DC. U.S. jobs data pointed to continued expansion last week. Photo: mari matsuri/Agence France-Presse/Getty Images 

So which is it? There has been lots of guessing about where we are in the cycle and a search for historical parallels. Is this 1994, a bond market bump before a huge leg up in stocks? Or 1998, when Russia’s default sent markets briefly into panic? Or is this 2007, moments before a crash?

A lesser-noticed moment worth studying is the credit correlation blowup of 2005. Markets were shaken then after auto makers Ford Motor Co mpany and General Motors Co mpany were downgraded to “junk,” sending bets made in the credit-derivatives market awry. That too didn’t have immediate consequences for wider markets or the economy: the corporate-bond market bounced back in the second half of 2005. And it wasn’t in the area of the market—housing—that ended up causing the crisis just over two years later. 

Spread of U.S. investment-grade corporate-bond yields over Treasurys

Source: ICE BofAML index via FactSet,

But it was an early sign in that cycle that investment strategies that rely on conditions persisting can reverse swiftly and unexpectedly. In the 2005 case, rather than betting on volatility remaining low, investors were using complex derivative trades to bet that corporate bond prices would broadly move in sync. When Ford and GM’s ratings were cut, that bet went badly wrong, as the auto makers’ bonds were slammed, while the rest of the market was steadier. The return available suddenly wasn’t sufficient for the risk taken.

The same is the case for investors who were betting this year that volatility would stay low.

Tight corporate-bond spreads and still-lofty stock valuations speak to a persistent belief that the world hasn’t changed, however.

One could read the start to 2018 in a reassuring way: the global growth story may yet win out.

But investors should probably take the turbulence seriously. Markets are changing. Now isn’t the time to hit the snooze button.

Germany’s Dangerous Political Marriage

Helmut K. Anheier

Angela Merkel, Acting Chairman of SPD Olaf Scholz and Chairman of CSU Horst Seehofer

BERLIN – More than five months after Germany’s federal election last September, a new grand coalition government – comprising Chancellor Angela Merkel’s Christian Democratic Union, the CDU’s Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) – has finally been formed. But there is little reason to celebrate.

Germany has endured nearly six of months under a caretaker government (the longest in the Federal Republic’s history), a failed coalition agreement, weeks of arduous negotiations, painful internal party rumblings, and much politicking. Moreover, a recent national poll dealt yet another blow to the center-left SPD, indicating that if elections were held today, the party would be outperformed by the far-right Alternative for Germany (AfD).

Add to that Europe’s ongoing right-wing backlash (exemplified, most recently, by Italy’s election) and the threat of a trade war with the United States, and Germany’s new grand coalition reeks of desperation. Not surprisingly, reactions to its formation were subdued, with the public and political insiders alike mostly just relieved to have the long ordeal behind them.

Germany’s new grand coalition – the third in Merkel’s long chancellorship – is a marriage of convenience: loveless, largely unloved, and devoid of any overarching vision. It is a good outcome for Germany’s short-term stability, especially with regard to Europe. But it is an uncertain outcome in the longer term, given the coalition’s considerable political baggage, and it is a bad outcome for democracy, especially at a time when populist forces are a growing threat.

One might argue that it is good for democracy that Merkel’s coalition has shrunk. Because the government parties control barely more than half of the Bundestag, they no longer overwhelm the opposition, rendering it irrelevant. The problem is that the largest official opposition party is now the populist AfD.

Moreover, the share of the Bundestag held by opposition parties that are only semi-loyal to liberal democracy – the AfD and its left-wing counterpart Die Linke (the Left) – now approaches one-quarter. Not since the Weimar Republic has a far-right party been the largest opposition force, or have anti-liberal forces controlled such a large share of the Bundestag.

This illiberal result is a direct consequence of the SPD’s participation in Merkel’s government.

Had the SPD remained in opposition, as it vowed to do after its poor election result, it could have spent the next four years renewing its platform and membership, while acting as a strong challenger to both Merkel and the right- and left-wing populists. A Merkel-led CDU/CSU minority government would have meant open debate on all major policy issues and legislative proposals, enlivening the Bundestag and showing the public that political parties matter, and that a grand coalition isn’t essential to progress.

Instead, Germany got a government that will implement a predetermined set of policies, contained in a 170-page agreement hammered out behind closed doors – one that promises more of the same. Its members will engage in all of the same professionally choreographed and well-rehearsed debates, the ritualistic display of legislative process that devalues parliament because the outcome is pre-determined.

For Europe, this means that no significant shift in Germany’s approach – for better or for worse – should be expected. French President Emmanuel Macron will not see a German hand reaching out to work with him on European Union reform, though he might be able to grasp a finger or two.

To be sure, the new grand coalition’s policy approach will be different in some respects from the last. In her determination to form a government, Merkel yielded to the SPD on important issues, including EU policy and labor-market matters. As a result, the overall legislative program outlined in the coalition agreement is more social democratic than that of any previous grand coalition.

But, ultimately, Germany can expect more of the same for the time being. This will keep the government stable in the near term. But it is a feast for populists – and a missed opportunity for democracy.

In fact, whatever stability the CDU/CSU and the SPD think that they have secured, there are plenty of reasons for concern in the medium term. The CDU is increasingly impatient with Merkel and her policy approach. And, though it is the largest party, it has relatively fewer government posts than the SPD, with no CDU cabinet minister hailing from eastern Germany, an AfD stronghold.

Unlike the CDU, whose members will soon feel short-changed, the SPD has rediscovered the virtues of internal democracy, which revealed a significant disconnect between the party’s leadership and its base. Whatever success the SPD has had playing the coalition game, the party’s participation in yet another Merkel-led government stands to cost it growing numbers of lower- and middle-income voters.

Both the CDU and the SPD face a shrinking electoral base and a falling supply of leadership cadres. As a result, both parties and their coalition will become increasingly unstable over time, a trend that would be accelerated by their poor performance in the 2019 European Parliament election, not to mention in Germany’s upcoming state and local elections.

Meanwhile, in the absence of a crisis that demands political attention, all of the problems and risks that Germany’s previous coalition governments have failed to address will continue to be ignored. At a time when German leadership is so badly needed in Europe, the country is set to continue to play a passive role.

Until recently, the SPD seemed to prefer a loss to a half-victory, much as a person might decide that it is better to be alone than in a mediocre relationship. But now the SPD seems to think that being in power, by joining the ruling coalition, is automatically better than being in opposition, no matter the cost. And the cost could be very high indeed. Loveless marriages can last a long time, but they rarely end well.

Helmut K. Anheier is President and Professor of Sociology at the Hertie School of Governance in Berlin.

‘Rolldown’ Shows Why the Bond Market Is an Unfriendly Place to Hide

The absence of a ‘rolldown’ is making the U.S. bond market an unfriendly place for investors

By Richard Barley

U.S. Treasury yields

Source: FactSet

For bond investors, a concept called “rolldown” is like a virtuous form of financial gravity, a force that generates returns without doing much work. A flattening yield curve, however, is threatening the physics that investors rely upon.

Federal Reserve Chairman Jerome Powell speaks at a news conference following the Fed’s decision to raise rates. Photo: aaron p. bernstein/Reuters

The signals sent by the Federal Reserve Wednesday suggests the yield curve could flatten further: Its rate increases will raise short-dated yields, but there is still skepticism that rates in the long term will be materially higher.

When the yield curve is steep, investors benefit from the yield on a long-term bond “rolling down” the curve. As a 10-year bond over time becomes a nine-year bond, all else being equal, its yield falls and its price rises, producing a gain above the initial yield when the bond is purchased. That offers protection for bond investors in a rising-rate environment, notes TwentyFour Asset Management.

Rolldown means an investor who holds a 10-year Treasury yielding 2.9% for a yearwould achieve higher returns the lower rates are at shorter maturities.

Source: Tradeweb

The U.S. yield curve still slopes upwards, with 10-year Treasurys yielding 0.57 percentage point more than two-year securities. But the further out you go, the flatter the curve gets. There is now only a 0.07 percentage-point gap between seven- and 10-year Treasury yields, a gap that has more than halved from a year ago. The potential for rolldown gains is small.

A similar phenomenon is showing up in U.S. corporate bond markets too, with the gap between short- and long-maturity bonds shrinking in both yield and spread terms. A number of forces are potentially at play here, as with the rise in Libor rates.

Yields on ICE BofAML U.S. corporate bond indexes

Source: FactSet

Higher U.S. Treasury bill issuance is competing for investors’ cash. And the pool of funding for short-dated debt may also have shrunk due to corporate cash repatriation, Citigroup suggests: if dollars can be repatriated and spent, they don’t need to be tied up in bond investments.

By contrast, steeper curves in eurozone government and corporate bond markets may make them attractive to investors. The European Central Bank’s negative-rate policy, which it is in no rush to change, is acting as an anchor for yields, reassuring bond investors. Coupled with the cost for foreign investors to hedge dollar-denominated bonds, U.S. bonds lose out despite their higher yields. All of that may lead to tighter U.S. financial conditions.

Gap between two-year and 10-year government bond yields

Source: FactSet

The absence of rolldown is just one factor in the investment equation, of course. But piled on top of a Fed that looks set to carry on raising rates and concerns about inflation, it makes the U.S. bond market an unfriendly place for investors.