On the Italian Prime Minister’s view of austerity

Italy’s new Prime Minister Enrico Letta is touted as a man who could change the politics of the EU. The Daily Telegraph in the UK even headlines his initial policy speech as “Italian PM Enrico Letta urges move from austerity to growth“. But is that really the case? I don’t think it is the case. And I will point to language in his speech for why as I develop a few background issues on Italy.

The last post I wrote on Europe was about the upcoming German elections. And my view here is that the SPD, a party ready for back-loaded austerity, is likely to play the pivotal role. The upshot then is that the German EU position will probably move from the dominant front-loaded austerity vehemently supported by the Bundesbank to a less dogmatic back-loaded austerity, with growth as a key policy plank. Previous SPD statements on this issue make that move clear.

I see Enrico Letta in the same mold.

This is the key part to take away from the Telegraph (I have bolded the most important bit):

“We will die of fiscal consolidation alone, growth policies cannot wait any longer,” Mr Letta said, noting that the country’s economic situation remains “serious” after more than a decade of stagnation.

However he pledged to stick to Italy’s budget commitments to its European Union partners, announcing he would visit Brussels, Paris and Berlin this week.

So, I would focus on the second paragraph and not the first. The media have focused on the first paragraph and not the second. What Letta is saying is what Hollande in France is saying and what Rajoy in Spain is saying, “relax deficit timetables and add growth to the austerity agenda.” That’s it. They are not saying, end austerity. I know this might simply be a rhetorical issue but I don’t think it is yet. Letta is talking about backloaded austerity with relaxed timetables and structural reforms. Until we see real growth agendas being developed instead of tinkering at the margins and talk of structural reform, backloaded austerity is not going to be a pro-growth policy evolution. It is austerity lite and that’s it. And I think this is as far as Europe is prepared to move at this time.

A number of events could turn Europe toward growth though. We could see the Netherlands fall further into recession. Germany could see a quarterly decline in GDP. France’s numbers could worsen. And Spain’s unemployment could rise further. These are the big euro zone economies. And each matters individually. Collectively, they make up the real euro zone core.

I believe Spain and Italy are near the breaking point, meaning the countries will throw off the austerity yoke if conditions deteriorate much further. But France and the Netherlands are also in peril and would support this if the situation in Spain and Italy is dire enough and the situation in France and the Netherlands has deteriorated. Germany could see the SPD in power if the economy turns sour. And that would give a green light to growth in conjunction with the events in the periphery and France and the Netherlands. I just don’t think we are there yet.

As for Italy, the numbers are not looking good, particularly in terms of credit growth and credit quality. Non-performing loans are increasing to an alarming level. And this is telling you that bank bailouts may be coming unless Italy can turn toward growth. The Italian government cannot afford to bail out any large financial institutions without significant private creditor participation. And even then any socialization of losses could move the Italians into OMT territory. Moody’s is now saying Italy may eventually need a bailout. And this would certainly be true if we get a bank crisis in Italy due to rising NPLs.

So, the pressure is on for a pro-growth agenda. Right now we are only getting a relaxation of targets. Even the OECD supports the targets being relaxed. And the rumour is that Italy could officially ask to be removed from the EU’s excessive deficit monitoring list as soon as next month. This would in effect allow Italy to pursue whatever fiscal policy it wants. And could mean Italy turns pro-growth very soon.

We are at an important moment for this to happen. The Wall Street Journal puts it well:

In July 2012, Italian 10-year bonds yielded more than 6%; this week they fell below 4%. Falling yields mean rising prices. The Italian economy, meanwhile, has been ugly. Gross domestic product in the fourth quarter of 2012 slid 2.8% from the same period in 2011, the sharpest quarterly fall since 2009. Italian unemployment was 11.6% in February, up from 10.6% in July. The tale is similar in Spain.

This dichotomy between bond performance and economic performance will not last. Crisis will return unless we see growth. And so Letta is indeed an important figure here. He does not have a green light to end austerity, nor is he saying he will do so. However, the potential is there. If Italy can get itself off the excessive deficit list, it can move to a pro-growth agenda while still nominally talking of making specific deficit targets. Stimulus would even be possible. But, if Italy remains an excessive deficit country under EU guidelines, it will have to continue its austerity drive, stimulus will be out, and growth will be a secondary consideration.