PrudentBear
Italy Looks Like This Cycle's Lehman Brothers
- by Martin Hutchinson
- November 14, 2011
There has been considerable discussion as to whether the potential Greek default makes it this cycle's Lehman Brothers, but that is surely wrong. Greece is much too small to destroy large areas of the world economy, as did the bankruptcy of Lehman Brothers. It is also being bailed out on exceptionally favorable, not to say squishy terms, as was Bear Stearns, where shareholders received an entirely unjustified $10 per share from J.P. Morgan Chase. To be Lehman Brothers, one must be a previously undoubted name, albeit with hidden weaknesses in management, whose bankruptcy is large enough to disrupt the entire global economic system and plunge it into depression for years thereafter. There is surely only one candidate for such an honor: it is not Greece, Portugal or Ireland (too small) or Spain (getting better management, and stronger than it looks – think Citigroup) but Italy.
In the past decade, Italy under Silvio Berlusconi has been considerably better managed than was Lehman Brothers. Berlusconi and in particular his finance minister Giulio Tremonti have an excellent grasp of Italy's weaknesses, and have tried within the constraints of the Italian political system to bring the country's bloated spending under control, improve its abysmal tax compliance and, as a corollary, reduce its excessive burden of taxes. In consequence, the Berlusconi governments have at least stabilized Italy's grossly excessive public debt, which had risen disgracefully from 30% of GDP in 1970 to 120% in 1995, but has been flat since then in spite of Italy's deteriorating demographic profile. They have also accomplished a considerable amount in pension reform, but have not adequately reformed Italy's corrupt public sector, its over-burden of regulation or its opaque and sluggish corporations.
The main criticism of the Berlusconi governments, which should really be directed at the leftist governments that intermingled with them, is that they have not prevented a substantial deterioration in Italy's relative productivity against its Eurozone neighbors, which has gradually made Italian exports uncompetitive and widened its balance of payments deficit to 3.7% of GDP.
Italy's problem is now a political one. Under Berlusconi it was mostly competently run and could hold its own internationally if only through the force of Berlusconi's personality. As the market figured out in its negative second-day movement after Berlusconi's departure, it is most unlikely that any Berlusconi successor will be anything like as good. Even if some figure from Berlusconi's own party, such as Angelino Alfano, were to succeed him, he would have far less authority over the fractious center-right coalition and far less ability to keep the necessary budget-cutting reforms moving forward. A "technocrat" successor such as the much loved (by the EU bureaucracy) Mario Monti would be much worse; he would secure a large handout from his friends at the EU or the IMF, and would then waste the proceeds in government aggrandizement, making an eventual Italian bankruptcy 12-18 months down the road all the more painful. Since the market would quickly spot the road down which a Monti government was heading, it would withdraw support for Italian bonds within weeks, well before that inevitable destination had been reached.
Of course, if Italy had kept Berlusconi there would have been a clear solution to its problems; departure from the euro. Unlike Greece, whose currency parity needs to drop to a third or less of its current euro parity to be viable, Italy becomes competitive with a devaluation of no more than 20% or so. With a Berlusconi to keep public spending under control, an Italy devalued 20% could even service its public debt, since its average maturity is relatively long and any cost increase resulting from re-lirazation could be easily absorbed over time. The current panic at bond yields over 7% merely reflects the youth and inexperience of the trading community, which fails to remember the double-digit yields of a generation ago.
Such a devaluation would break up the euro as it currently exists, since Italy unlike Greece or Portugal is a major component of the currency. Indeed it would almost certainly also lead to a departure from the euro of Spain, France and probably Belgium, since they would find themselves more uncompetitive through the Italian devaluation. However it would not remove the currency bloc altogether, which could happily continue with Germany, the Netherlands, parts of Scandinavia and its highly competitive and flexible East European members Slovakia, Slovenia and Estonia. There would be no world recession, and no major bond defaults beyond Greece and possibly Portugal.
As they have done and are continuing to do in Greece, the EU panjandrums by taking over the management of Italy by putting in their man Monti and providing limited bailout help will make matters much worse. For one thing, their solution and the austerity they will call for will have very little legitimacy. As we saw only last week with Ohio voters' rejection of the Republicans' perfectly sensible reforms of that state's public sector workforce and its pension and healthcare rights, claims of actuarial catastrophe have very little salience with the electorate. Voters don't understand the actuarial calculations involved, which are of necessity opaque and they rightly suspect that the political class is capable of producing spurious scientific-seeming justifications when it wants to do something.
The same distrust will attach itself to Monti's calls for austerity, and whereas Berlusconi's policies could be opposed within the system by aligning with the parliamentary left, opposition to Monti's apparently high-minded reforms, which will not tackle the corruption endemic in Italian politics, will spill into the streets. With the budget more out of balance than under Berlusconi because the politically connected lobbies that Monti has brought with him will seize the opportunities to seize available resources, the markets will wrongly perceive Italy as being as much of a basket case as Greece, and close access to Italian government re-financing.
Within a very short period, that may not drive Italy out of the euro, but it will produce a default on Italian debt that could have been avoided with better management. Since Italy's debt is so huge, the resources for a full bailout do not exist (even Germany's taxpayers suffer under a high tax regime that is within a few percentage points of becoming counterproductive) and so the southern European government securities market will collapse.
Just as with Lehman Brothers, regulatory actions, and not just the misdirected short-term maneuvers of politicians and banks, will bear a considerable share of blame for the debacle. In this case, the Basel rules assessing OECD government debt as having zero risk and thus requiring zero capital allocation will be most to blame. Those rules allowed banks, without constraint from their capital inadequacy, to load up on debt that had less economic reality behind it than the debt of any solid well-established corporation.
Britain came close to default in 1797, not because of any failure of its burgeoning economy, but because its government approached the limits of its tax capacity at around 20% of GDP (and France suffered the revolution eight years earlier through a similar problem). In modern societies, with income taxes and the great majority of populations well above the subsistence level, national tax capacities are well above 20% of GDP, more like 50%. However they are not 100% or even 70% of GDP, nor can they ever be anywhere close to those levels. Taxation at that level produces economic decay even in the short term, as Sweden discovered in the 1980s.
With twentieth century welfare systems strained by the aging European population, it was always absurd to assume that any modern government's debt was "risk-free" except for that of a few countries like Singapore and South Korea whose tax systems were operating far below their maximum capacity. Countries can increase their own economies' viability and their governments' tax capacity, as a percentage of GDP, for a few years by a one-off devaluation, but as various South American states have shown (albeit at a lower level of income) that too is only a short-term solution. Whereas Italy could probably service its debt through austerity and devaluation (as Britain did after its 1967 devaluation) Greece is quite unable to reach any such equilibrium. In Greece's case, devaluation is necessary to get the economy working at all, but after devaluation output will still not be great enough to service the country's gigantic debt.
The last three years of ultra-low interest rates and government profligacy and meddling thus seem all too likely to produce a second financial crisis, an unprecedentedly short time after the first. Presumably the Reinhart-Rogoff argument in their book "This time is different" that financial crises are especially difficult to emerge from will apply with redoubled force to the emergence from two crises rather than one. Sadly, even this second disaster seems unlikely to be sufficient to discredit the policy foolishnesses that have caused both crises or to prevent a spiral of money creation, meddling and debt that will lead to a third crisis and long-term economic decline.
We are supposed to be an intelligent species, which can learn from our disasters. With such learning very unlikely, the global economy may be destined to decades of decline, from which emergence may be impossible.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site www.greatconservatives.com–and co-author with Professor Kevin Dowd of "Alchemists of Loss" (Wiley – 2010). Both now available on Amazon.com, "Great Conservatives" only in a Kindle edition, "Alchemists of Loss" in both Kindle and print editions.
Views are as of November 14, 2011, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Federated Equity Management Company of Pennsylvania
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The opinions expressed are those of the author and do not necessarily reflect those of www.PrudentBear.com. This is not a recommendation to buy or sell any security, commodity or contract.
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