Can Mario Monti save Italy from default or economic collapse?
This is the question everyone has been asking. And I will be addressing this today at 1230 on Business News Network in Canada with another guest, Ryan Avent from the Economist, and presenter Howard Green. Before I get into my answer, let me run a theory I have by you.
When I think about predicting outcomes, I think in probabilities using a decision tree matrix. Basically, it goes like this:
- if A, then either B, C or D; if B then E or F; if C, then G or H and if D then I or J.
This is a stylized mental model, of course. I don’t really think you can put precise numbers on squishy outcomes in the political economy. But you can run through the high level thinking and get to a reasonable understanding of causality and the likelihood of events.
When I see a guy like Mario Monti in Italy or someone like Lucas Papademos in Greece talked about as an unelected technocrat taking over in the midst of crisis, this probability analysis comes to mind. Technocrats are pragmatists who want to eliminate tail risk. What that means is reducing the potential for black swan events and I think you get to the black swan events by widening the decision tree. Let me give you a purely numerical example.
Say I am thinking of a four-stage decision tree with binary outcomes, that is to say each time I move to a decision point its either A or B. That’s a narrow decision field. But even there, two outcomes become 4 possibilities that become eight and then 16 by the time you reach the fourth stage of the tree. Sixteen outcomes is a lot for someone to plan for, but not a ridiculous amount. After all some of the outcomes have limited probability of ever occurring, so you can gear your policy response to the main three or four outcomes.
But what if you are in a more unpredictable situation where there are 5 potential outcomes at every point in the decision tree. Five outcomes are not that many more than two. A-ha, but in a multi-stage process the whole thing quickly spirals out of control. Suddenly 5 becomes 25 which becomes 125 and then 625. And 625 is a lot larger than 16. There’s no way a Mario Monti or a Lucas Papademos can deal with 625 potential outcomes without hazarding some serious tail risk aka black swan events. This is where policy errors are made and technocrats, innately sensing this look to narrow the scope back down.
So I think Monti and Papademos are going to try to shoehorn the standard policy responses into the situation in order to reduce the range of outcomes they have to deal with. In a practical sense, that means going with the standard formula of cutting budgets, selling state assets and working within the Euro framework.
I summed up the situation in Italy this way yesterday:
- Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. It won’t ever be able to do so.
- Therefore, yields for Italian bonds must come down or Italy is insolvent as it must roll over 300 billion euros of debt in the next year alone.
- Austerity is not going to bring Italian yields back down. First, Italian solvency is now in question and weak hands will sell. Moreover, investors in all sovereign debt now fear that they are unhedged due to the Greek non-default plan worked out in Brussels last month. As Marshall Auerback told me, any money manager with fiduciary responsibility cannot buy Italian debt or any other euro member sovereign debt after this plan.
Conclusion: Italy will face a liquidity-induced insolvency without central bank intervention. Investors will sell Italian bonds and yields will rise as the liquidity crisis becomes a self-fulfilling spiral: higher yields begetting worsening macro fundamentals leading to higher default risk and therefore even higher yields.
It is this train of thinking that leads me to the conclusion that the ECB will eventually step in. So I say, no Mario Monti cannot save the day. What about other nodes on the decision tree?
At stage 1 here, Monti will try to cut the deficit. But, as you have already seen, this will likely reduce revenue and taxes due to the negative economic effects. That would mean the austerity would be ineffective. I say 70 or 80% likelihood that deficits are not reduced.
But even so, at Stage 2, the question is whether just saying you’re going to do so is enough to bring yields down. My answer is no. Again, let’s say this is a 70-80% probability. That leaves 20% yes.
If the answer is no, at Stage 3, the ECB steps in (or it doesn’t). If the answer to yields coming down is yes then Italy gets to live another day and we can move to the fiscal integration with exit clause approach that Germany is leading.
I could go on, but you get the point. Until the next elections in Italy, when things get unpredictable due to politics, the line seems pretty narrow. Italy will try to cut. Either their efforts convince markets or they don’t. if they do, we move to an integration with penalties euro zone. If they don’t the ECB will have to decide whether and how to step in. If the ECB does not step in, it means economic collapse (or Italy could leave the euro). If they do step in, Italy is saved but then the decision field will expand: how do they step in and for how long? Does this help Spain and Belgium, etc, etc?
That’s a lot to think about. And so it means risk off until we can narrow this decision tree.
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