What is your barometer for political talk? Where do you go to get informed? I think most people would say that polls are a useful, if often wrong, source of information, then there are the International Monetary Fund reports, the European central bank forecasts, newspapers, economic reports, financial institution analyses (which are basically economic reports) etc. I worked out some time ago that most of these were self serving and although some of that information is useful it shouldn’t ever be a real gauge for what the average man on the street is really thinking or doing.
For me, I get that information somewhere else….mercato Trionfale in Rome where I do my weekly food shop. I find it a hub of differing opinions and characters that all have something to say on the state of the country, world politics and the health of their country. OK, I admit it is probably not quite as well researched as the other methods mentioned above, but I do find it gives a different perspective on what people are thinking.
However, whilst writing this I stand humbled because I attended a webinar on the state of the EU, which I will write about for you here. The webinar was hosted by a large Assurance company called Utmost and they had as their guest speaker a man named Ashoka Mody. I openly admit I had never heard of him before but he has a string of book titles to his name, a career at the World Bank and also influence in the EU’s bailout of Ireland in 2009. The reason I stand humbled is because he was a pretty straight talking economist, it would seem. He had very strong opinions on what is likely to happen in the EU as a result of the COVID-19 crisis and particularly how the crisis will develop in Italy, which is, of course, very important to a lot of us.
So without further ado, here goes my summary on that webinar and the evolving situation and some of the thinking about the future of ‘Il bel paese’ and the European Union.
Where is the money going to come from?
Let’s start by saying that whatever predictions are currently being made about the financing needs from the effects of COVID-19, the true reality is that it is likely to be a hell of a lot more than we think. It is likely that the global effects of COVID-19 are going to be felt long after the virus disappears (assuming it doesn’t make a return in the winter) and to return to normal the best estimates are that we will need at least 2 years for travel, business and supply chain to return to pre virus levels.
At the moment there is little point looking much further than 2020 as this is so unprecedented no-one really has any answers, but the realistic thinking at the moment is that the cost for BOTH Italy and Spain will be upwards of 20-25% of their GDP in 2020. In monetary terms that is a potential €500 billion black hole in the finances of Italy and about the same for Spain.
To look at the viability of filling this hole, we have to turn to the EU. Just last week they announced a potential €500 billion recovery package which, as we can see, does not even come close to the potential needs of the countries worst affected by the virus. So, what do the EU members states really need from the EU now? The answer is not a financing solution because they will never agree a package big enough as we will look at below. What the EU needs now is a political revolution and who would like to place any bets on that happening?
Normalcy: the condition of being normal; the state of being usual, typical, or expected
I am sure you, like me, have concerns about how the EU is going to deal with this and how Italy will extract itself from this mess, but my more immediate preoccupation is what happens to all the small businesses, restaurants, bars, pubs, shops, etc. How are they going to survive this? And I don’t just mean the lock down period, because any extended set of conditions put on a return to normalcy will, in turn, have a further damaging effect on the supply chain. The best economic forecasts predict a return to growth for most countries in Q4 2020, but the likelihood is that growth will only return, after a severe contraction for all of 2020 and a return to growth in the first quarter of 2021.
Cogs and Wheels
We have to imagine that the whole world economy is a machine which is comprised of cogs and wheels and for the machine to keep working all the cogs and wheels must keep moving. If one slows then it inevitably has a slowing effect on the whole machine. Not only that, but if we imagine the supply chain of a restaurant for example (I choose this because there may be social distancing rules applied to restaurants when they reopen) and assume that they can only open initially at the capacity of 30-35% of their pre virus levels, then effectively that slows the whole supply chain down to 30% as well.
It is not correct to say that it will affect only the restaurants, but also the lavanderia that cleans their table cloths, the food suppliers, the deliveries of detergents, the wine consumption etc. This affect of an extended return to normalcy could be the difference between many businesses reopening and staying permanently closed.
We can extend this thinking globally as well based on different countries coming out of lock down at different times. If we think about global trade in its most basic definition it is an exchange of goods. A buyer finds a seller and they make an exchange. But, if in the case of Italy, it comes out of lock down and businesses start again, will they be able to find buyers, or even sellers of their goods and services if other countries in the world, the USA, the UK, Russia, China etc have continued restrictions in place themselves and they can longer trade in the way they did before?
The system is a machine of cogs and wheels which are all inter-dependant on one another. When the wheels stop turning it affects the whole machine.
The ripple effects in the EU?
The first thing to remember about the eurozone economies is that coming into this period, nearly all the eurozone countries were in or near recession. Italy has been in a low growth, low inflation cycle for about the last 30 years. This crisis is expected to cause respective contractions to the economies of Italy and Germany of -9.1% in 2020 and -7% followed by growth in 2021 of +4.8% and +5.2%. Unfortunately the reality is likely to be much worse.
Italy’s national debt to GDP ratio is predicted to rise to 155% and it could very well fall into a persistent deflation spiral. This is very bad for business, the economy and the country as a whole because it will exacerbate the effects of the debt, meaning that Italy has to pay even more back to meet its debt obligations in world financial markets, meaning less investment in infrastructure schools, hospitals, and public services. Could we see even more forced privatisation of public utilities and services?
In short this is a very bad situation!
As I also explained above, the effects will not only be isolated to Italy and Spain, but the rest of the EU. For example, French banks have lent approximately €300 billion to Italian banks in recent years. Italian banks are almost inevitably going to wobble after this crisis and we might have to expect some bank failures (the subject of my next E-zine). But, if they default on their obligations, what will be the ripple effect on French banks? And French banks are not the only banks that have lent to Italian banks in recent years. Also, Greek, German, Spanish, Portuguese…can you see the trend?
So how will the EU deal with this crisis?
The short answer is don’t expect anything from the EU. It is likely that we will see a new idea almost every day in the press but none of these will solve the problem because the single biggest failure of the EU project is no political alignment. We cannot fix a financial solution without first having a political solution, because any political solution ultimately means that there will be a fiscal transfer from one country in the EU to another, and neither the Dutch nor the Germans are willing to take that risk.
The European central bank already owns 23% of Italian government debt and to bear the cost of the COVID-19 breakout it would need to purchase another 25%, meaning that the ECB would be holding nearly 50% of Italian government debt. If we remove the morally right thing to do for a moment, it is perfectly understandable that the Germans and Dutch would not want to be on the hook for this amount of debt should Italy fail to pay its debt obligations in the future, because of its inability to manage its economy.
National interest will always come first, over EU solidarity. Let’s bear in mind that Germany is also going to have to apply it’s own fiscal stimulus and if EU bonds were created then that would mean a transfer of approximately €200-300 billion euros of government debt transfer from Italy to Germany alone. It might be the morally correct thing to do, but is it the practical thing to do? Is it right that other EU states should shoulder the burden of debt from less efficient Southern European states?
A quick look at history
You may think that these are historically unprecedented political times, but you would be wrong. We only need to look at the USA to see what happens when no political union is in place:
Between 1776 and 1789 the US was like Europe is today. It was a group of federal states that all operated their own finances and budgets. This was also the time of the War of Independence from Great Britain. In 1788 a currency union was formed and the US dollar was granted as the common currency across the USA, allowing them to spend without the worry of exchange rates. Following the currency union a federal government was formed in 1789. At this point the federal government now had a right to tax the nation. However, this led to a fractures between individual states, principally those in the north and those in the south and lead to the American civil war in 1861 – 1865.
So there we have an example of a similar situation as that of the EU, but with one major difference: The EU doesn’t have a federal government in place and without a federal government, (but a currency union), then the central bank (the ECB in the case of the EU) does not have the authority to bail out the individual member states in the time of need. In other words the central bank cannot play it’s role of being a lender of last resort. Herein lies the problem.
In the USA, as we have already seen in past weeks, they will essentially ask the Federal Bank to print as much money as is required to bail out the nation. If they lend to any institution, municipality or corporation and that entity fails to pay their debt obligations then the taxpayer will bear the burden for that debt and it will be added to the governments existing debt obligations, which they can then, over time, work to payback or erode through inflationary measures.
Italy, as per all EU member states, have no lender of last resort, (independent central bank) to which they can turn to bear the cost of the measures introduced during the COVID-19 outbreak.
So where do we go from here?
Well, it is quite clear that this is going to swiftly move from a health crisis to an economic crisis and then even more quickly to a political crisis.
There seems to be no political will in the EU to create EU Bonds to alleviate the burden on Southern European states who were most severely affected by COVID-19. The only solution being offered at the moment is to extend the European Stability Mechanism to Italy, Spain and other affected states which is (without going into details) an offer of loans at low to zero interest rates, but which must be paid back and with conditions attached. This is something which Italy is going to try hard to fight against. This isn’t a financial crisis but a health crisis and they believe, and I am with them despite the financial and political consequences, that the EU must bear the burden of the additional debt created because of this crisis. Italy does not want to take loans with conditions attached because it is essentially the same financial treatment as that imposed on Greece in 2010. The only outcome from that was complete financial hardship and a failing economy. Italy is, obviously, keen to avoid the same fate as is Spain.
So that leads us nicely to the term which we are likely to see in the press in the coming weeks and years ahead: QUITALY.
Is Italy going to decide to do a Brexit and leave the EU. Before any Brits, like myself, who have taken citizenship in recent years, start to panic about the possibility of Italy leaving the EU as well, it should be noted that the Italian constitution would prevent a hasty and quick action, (They couldn’t do a Brexit!!) and even if they were to hold a referendum on the matter it would take years of negotiation within the warring Camera dei Deputati and Senato to even arrive at a referendum.
So we have a long way to go yet, but one thing is clear. Political opinion is changing in Italy. In recent surveys 42% of Italians said that they didn’t want to leave the EU, but an equal percentage said that they would want to. 50% of Italians said that they did not want to take any money from the European Stability mechanism if it came with any conditions attached, but conditionality will be key to the future of the EU, and the economic health of Italy.
As you might imagine at this time, this is stoking more populist revolt and Matteo Salvini is now number 1 in the polls. The Frattelli D’Italia led by Giorgia Melloni (who is a far right party allied with Salvini’s, La Lega) is also polling well and her ratings are rising fast. It is not beyond imagination that when the covid virus passes, a political crisis will quickly ensue, Conte and the M5S coalition will hold on to power by a thread but a Salvini / Melloni coalition could be very quickly ushered into power in the not so distant future. Prepare yourselves!! I can only add that my conversations with Italian friends, people I chat to at the market and with some clients, has turned from being very EU positive to negative. One of my clients probably hit the nail on the head when he said, “if the EU cannot get their finger out on this one, then I can’t really see the point of a politically unified EU anymore and it should return to it’s roots and become merely a trading block, with freedom of movement”. I am inclined to agree.
What can we expect?
The Eurogroup [the group of EU finance ministers] were meeting on Thursday 23rd April to discuss the future. Conte was to meet with them to try and negotitate a good financing outcome for Italy.
The likelihood is that the EU will do what they are good at and kick the problem into the long grass. They will not provide any concrete solution, which will throw Italy and possibly Spain into a spiral of recession, deflation, more political infighting and economic hardship. The Eurogroup only has €500 billion euros at it’s disposal to provide unemployment insurance, economic stimulus, and the fight the COVID-19 virus across the EU. It is nowhere close to the amount required. The ball park figure would be closer to a € 1trillion. The sad fact is that the European Central Bank could print € 1trillion euros, if only it had the mandate to do so from all EU member states.
In truth, Germany will likely have the last say. Brexit has already left a funding hole of approximately €60 billion in the EU budget and so the logical conclusion is that Ms Merkel will give the problem the kiss of death by requesting that the issue of funding is placed in the EU budget and each country will be left to fight it out with other member states as to who pays what and when. In others words it will fall into the bureaucracy of the EU. The problems will persist in Italy and economic hardship will worsen.
So what does this mean for our money
Well, to try and leave this E-zine on a positive note for investors, at least, we can be thankful that there is a whole world out there in which we can invest and whilst Italy likely sees hardship, other countries will exit this crisis and prosper. One country that springs to mind is China. So for all our concerns about the country that we live in, we shouldn’t worry too much about our money. I can’t say for sure when stock markets will recover fully. We may be waiting until the end of this year at the very earliest, but they will and with a well managed, diversified portfolio with good oversight, then your portfolio will recover as well. The economics will play out over a much longer period. One upside for currencies is that it could weaken the Euro which would make those who have assets in USD or GBP, for example, worth a lot more. Maybe a return to the heady days of 1:45 GBP to 1 €?
All I can say that it is all to play for. In the meantime, I will be taking a closer look at Italian banks in my next E-zine as they could be a huge risk to use, and to financial markets in the months and years ahead.