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The Deleveraging Mirage: A Careful Look at Italy Today

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Europe’s most distressed countries should see their debt peak in a year or two, before descending to more manageable levels by 2020. Or at least that’s what the IMF, the European Commission, and the credit rating agencies all claim. Coming on the heels of the 2012 crisis, this is a heartening forecast—but a pretty surprising one, too. Just what is it based on? We’ve examined these institutions’ various scenarios for Italy and Spain, whose mounting sovereign debt burden loomed large in 2012, and for France, where the sovereign debt outlook raises a whole host of questions. Our assessment is as follows:

  • All these projections are marred by overly-optimistic assumptions about these countries’ structural growth outlook and their ability to sustain highly restrictive fiscal policies. This makes subsequent revisions to the projections a foregone conclusion. 
  • Italy is a case in point: the projected growth rate is so fanciful that the country stands virtually no chance of deleveraging as hoped. More conservative forecasts would preclude the prospect of Italy stabilizing its debt in the next few years. They would show rather that by 2020, its debt-to-GDP ratio should verge on 140 percent.
  • Spain seems to be in a better position to achieve such stabilization in the near term. Not only is its debt-to-GDP ratio 30 percentage points lower than Italy’s, but its potential output is apparently on the way up. Italy’s isn’t.
  • Despite recent setbacks, France still seems to have the means to reverse its debt trajectory. If we assume average real GDP growth of 1.2 percent a year between 2013 and 2020, the country should be able as of 2015 to reduce its debt level just by maintaining a primary budget surplus.

What emerges from this analysis is that Italy is the exception—and unquestionably the most vulnerable of the large eurozone economies. This suggests that we’re in for further bad news once today’s widespread projections come up for revision. Which they probably will after the Italian elections, especially if—as is likely—the new government lacks the leeway needed to convince investors that it can and will do something about the country’s huge debt overhang.

When the Eurozone Policy Mix Becomes a Weapon of Mass Destruction

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Last week’s economic data should have eliminated any lingering doubts about the state of the eurozone. The recession has definitely arrived in the single-currency countries—all of them. Although the third-quarter figures turned out to be slightly less bleak than suggested by surveys this summer, that doesn’t alter the overall picture. In fact, the eurozone will probably pay dearly in the fourth quarter for the unexplained rebound in automotive output that drove the better-than-expected performance, since order backlogs have shrunk dramatically and automakers already plan to mothball significant production capacity in November.

The U.S. Economy: Still Far From the Mark

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In an environment dominated for months by mounting fears of the worst, pleasant surprises understandably create a fair amount of enthusiasm. That leaves economists with the thankless task of urging the enthusiasts not to get their hopes up too fast. The U.S. economy has shown encouraging signs in the past few months, including revival of the housing market, higher consumer sentiment, and, in the past few days, good news from the job market. But the country is not out of the woods yet.

  • The jobless rate has fallen to its lowest level since 2008. A less heartening statistic, however, is that private-sector employment has yet to recover to where it stood in 2001. In this area, the U.S. economy has not performed any better than the French economy over the past eleven years!
  • The housing market is unquestionably picking up, and all the evidence points to further improvement down the road. But the key drivers of demand have taken quite a bruising from the weaker economic environment of the past few years, and real estate has lost a good deal of its power to tow the rest of the economy in its wake.
  • Corporate profits in the U.S. are at a historic high. However, decelerating productivity growth has led to a significant slowdown in the rise of earnings over the last several quarters. The upshot is that by any standard, developments on the investment front have been extremely disappointing.
  • Lastly, while American pragmatism can be expected to bring about a postponement of the deadline for balancing the budget, thereby limiting the “fiscal cliff” risk to the economy, the fact remains that the country’s public finances are in alarming shape. The upcoming negotiations will necessarily turn the spotlight on one of the most disturbing issues facing the United States.

Recession for Everyone, Germany Included

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The current consensus will eventually collapse in the face of statistics released in the last twenty-four hours. The IFO’s July Business Climate Survey abundantly confirms a scenario that has looked inevitable since early spring—Europe has unquestionably entered a recession and no country will escape it. This should be a sobering warning to consensus economists, who were still predicting an improved outlook for 2013 in July, with 0.5 percent growth in the eurozone as a whole, 0.7 percent in France, and 1.3 percent in Germany! But while this grim news ought to prompt a wrenching re-evaluation, the forecasting community shows such inertia that we are unlikely to see any real change in the consensus until November or December. By then, it will be impossible to deny the undeniable: in 2013, the recession will spread from Southern Europe to the entire rest of the region, and the sovereign debt crisis will become increasingly hard to untangle.

 

€4.5 Trillion Balance Sheet Needed for the ECB to Achieve the Same Firepower as the Fed

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Since the onset of the financial crisis, the European Central Bank’s balance sheet has doubled in size—from €1.5 trillion in June 2008 to €3.1 trillion in August 2012. That’s impressive, but much less so than what most of the other major central banks have done, often in a much shorter time span. So the idea that the ECB is about to make use of further unconventional tools should be no cause for concern. In fact, for the eurozone to stand a fighting chance of survival, the ECB will have to pull out all the stops, going at least as far as the Fed and the Bank of England. That will mean boosting its balance sheet by another €1.5 trillion or so to a total of roughly €4.5 trillion. What should be a cause of concern is that the break with the past the central bank is about to make will prove to be less bold than required.

France’s 3-Percent Deficit Target for 2013: Harder and Harder to Believe

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Although the French government has repeatedly described its 3-percent deficit target for 2013 as “inviolable,” this claim should be taken with a large grain of salt. The fact that investors are willing to pay to hold French sovereign debt suggests that the government has done a good job communicating—no small achievement just when one neighboring country after another is forced to borrow at exorbitant rates. But let’s not be gullible: there is no way that France can meet its target. Even if the official growth forecasts were accurate—0.3 percent in 2012 and 1.2 percent in 2013—this would be an ambitious goal. If the economy goes into negative territory, it will be downright unattainable. Coming after three quarters of stagnation, the steady slide in economic activity since early summer will push France into a full-blown recession. We estimate that GDP should basically be flat this year, before decreasing by at least 0.7 percent on average next year. This differs markedly from the government’s current forecasts, the basis for its budgetary assumptions for 2012 and 2013. With a shortfall totaling 2.3 points of GDP (0.4 points in 2012, 1.9 points in 2013), meeting the 3-percent target in 2013 would require cuts equal to 3.6 points of GDP over those two years, in contrast to the 2.6 points initially forecast!

In other words, it would require unprecedented savings, two thirds of them in the coming year. If actually carried out, they would make France the eurozone’s star pupil in the field of fiscal retrenchment, but it seems unlikely they will be. In fact, it seems more like the government is playing with dynamite.

After a Summer Break, The Carrot and the Stick

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After several weeks of major uncertainty, investors hailed the ECB’s promises of late July, and the month of August provided a welcome lull. The two key questions are how long it will be before they start demanding follow-through on those promises, and just what the much-awaited measures will entail. By requiring Spain and Italy to request assistance from the EFSF rescue facility before agreeing to purchases of their government debt, the European leaders will only drive the EU even further into the morass it has been mired in for more than two years. And a growing number of countries in the region will inevitably get dragged down in the process. Unfortunately, those leaders show little inclination to do otherwise.

Spain: Spiraling Downward in Greek Fashion?

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The current approach to managing the sovereign debt crisis is so absurd that it will wind up destroying the European Monetary Union—perhaps even faster than anyone dares to imagine today. With the economy in free-fall since mid-spring, pressing ahead with fiscal adjustment programs means exposing Europe’s crisis-ridden countries to major risks.

Spain’s creditors initially greeted the new austerity plan unveiled by the Rajoy administration with a sigh of relief. Immediately after the prime minister’s announcement, long-term interest rates fell by a substantial 20 bps to 6.60 percent. The pledges offered by the Spanish government in exchange for greater flexibility in meeting the deficit reduction targets set by Brussels seem to have convinced observers. What probably made the biggest impression were the promises to overhaul public administration, with the number of local government councilors to be cut by 30 percent, and at the same time to raise the value-added tax rate by three percentage points.
Yet there are serious grounds for concern about whether Spain can overcome the crisis in this way.