A rogue nation is needed to exit the Eurozone

I plan to send my final manuscript for my Eurozone book to the publishers tonight. I have some final checks to make on the 390 pages. I hope it will be published in both English and Italian later in the year. Obviously I will promote it here once it is ready. The book contends that the Eurozone is structurally biased towards stagnation because of the neo-liberal rules that constrain national governments from dealing with large spending collapses with appropriately scaled fiscal responses. The crisis in now into its 6th year and there is little sign that the stagnation is over. Indeed, the latest data would suggest that some of its largest economies are going backwards still. Italy has just announced it is back in recession and factory orders to Germany have plunged. I have been saying it for years but repetition is no sin – they should dismantle the currency union in an orderly manner and allow the national governments to return to growth in their own way. The nations are incapable of doing that collectively given the neo-liberal Groupthink that has them in a vice. So, a rogue nation is needed to break out of the straitjacket and provide a blueprint for the others. Italy should be that nation. In many ways it has panache and flair – it is time to show it in this specific way. Eurostat published the latest – inflation data – for Europe on July 31, 2014.

The following graph shows the annual inflation rate for the Euro 18 nations and Greece from January 1995 to June 2014. The Eurozone is heading for a deflationary situation (negative inflation rate – that is, prices dropping across the board). Greece has been in that state since March 2013.

Above all, it signals that total spending is too low and if the private sector won’t resolve that then fiscal deficits have to rise. Exactly the opposite to what is happening in Europe under the iron grip of the Troika.

The layperson often thinks that falling price levels are a good thing. But the reality is that deflation is incredibly damaging to an economy. Why is that so? There are several reasons why an economy wants to avoid deflation.

First, debtors are hit with rising real debt burdens and falling asset prices. Creditors gain but the overall impact on aggregate spending is negative because debtors cut their spending by more than creditors increase theirs. In turn, this can promote further deflation and a spiral into depression.

Second, the falling asset prices, particularly home values, lead to bankruptcies and sharp decreases in mobility as workers get locked into housing they can not sell without massive losses. In such cases, even if the unemployed worker desired to move elsewhere in search of work, their housing situation makes that nigh on impossible.

Third, deflation usually only occurs when there is mass unemployment.

Fourth, falling inflation leading to deflation engenders expectations of further price falls, which has two negative impacts. Consumers and firms will postpone spending in the hope they can get the product cheaper later on. Further, people postpone decisions to borrow because there are no losses involved in holding cash balances (the real value rises) and it is reasonable to assume interest rates will be cut thus making loans cheaper in the future.

All of these impacts reinforce the deflationary spiral downwards, building on each other to make matters worse.

On the same day (July 31, 2014), Eurostat released the latest – Unemployment data – for Europe.

The unemployment rate for the Eurozone was 11.5 per cent, down by only 0.1 percentage points from the May 2014 level and only 0.5 points lower than a year ago.

Unemployment rates in Spain remain at 24.5 per cent, Italy 12.3 compared to 12.2 per cent a year ago; Greece last reported in April 2014 to be 27.3 per cent and static. Compare that with Iceland which has seen unemployment drop over the year from 5.6 per cent to 5.1 per cent.

Youth unemployment (under 25s) rose to 53.5 per cent in Spain up from 53 per cent in May; Greece unreported since April 2014 when it stood at 56.3 per cent. In Italy, it rose to 43.7, up from 39.4 per cent a year ago. Compare that with Iceland which has seen youth unemployment drop over the year from 11.3 per cent to 9.4 per cent.

Eurostat also announced (July 29, 2014) that the “Business investment rate was down to 19.3% in the euro area” (Source), which corresponds to a drop in investment itself of 0.8% per cent in the first-quarter 2014. So not only a spending hit but also a slowdown in capacity building, which will undermine future growth.

The investment rate is heading to its lowest level since the Eurozone began. It was 18.7 per cent in the first-quarter 2013 and 19.2 per cent in the third-quarter 2013. It is heading back towards those levels.

Last week, we also learned that German factory orders are now in decline on the back of weak demand (spending). The German Federal Ministry for Economic Affairs and Energy released new data last week (August 6, 2014) – Entwicklung des Auftragseingangs in der Industrie im Berichtsmonat Juni 2014 – which indicated that:

1. Factory orders had slumped by 3.2 per cent in June (from May) and had fallen by 1.6 per cent in May (“im Juni preis-, kalender- und saisonbereinigt gegenüber dem Vormonat um 3,2 % zurückgegangen. Im Mai waren sie um 1,6 % gesunken”).

2. Capital goods (plant, machinery and equipment) were down by 6.4 per cent, reflecting the drop in the investment rate (“Von den geringen Großaufträgen waren insbesondere die Bestellungen für Investitionsgüter betroffen (-6,4 %)”).

3. The major decline in orders came from within the Eurozone where there was a decline of 10.4 per cent (see (AUFTRAGSEINGANG in der Industrie).

4. Demand for German capital goods from other Eurozone nations fell by an amazing 19.5 per cent in June 2014, signalling a major cutback in investment elsewhere in the Eurozone.

The following graph shows the monthly and annual change since January 2008 in the All Industries orders index produced by the BfWE (German Federal Ministry for Economic Affairs and Energy).

Germany’s – Ifo Business Sentiment Index – also fell in July from 109.0 points to 108.0 points. The press release said:

This marks the third decrease in succession. Assessments of the current business situation were less favourable than in June. Companies were also less optimistic about future business developments

The Ifo survey produced the following graph of the business climate in Germany.

And then the big news came last Wednesday, when Istat.it (the central statistics office) published the – Preliminary estimate of GDP – II quarter 2014 – that revealed Italy was back in recession having endured a decline in real GDP of 0.2 per cent in the second-quarter 2014, which followed a decline of 0.1 per cent in the first-quarter 2014.

In the last 12 quarters, Italy has recorded on one quarter of positive growth, which was the fourth-quarter 2013 (0.1 per cent).

Over the year, the Italian economy has shrunk by 0.3 per cent.

Since March 2008, the Italian economy has shrunk by 9.1 per cent in real terms.

The estimates are preliminary and will be revised but that will not alter the message – Italy is faltering and its membership of the Eurozone is the direct cause.

The following graphs shows the growth in real GDP (quarterly) since June 2008 up until the June-quarter 2014. It is hardly an inspiring endorsement for Eurozone membership.

But you get a better idea from this longer series from March 1992 of what has been going on in Italy when its economy has been held in a vice like grip of fiscal austerity – first, with the convergence farce leading into Stage III entry (the final stage that launched the currency), the fiscal crisis in the early 2000s (when Germany and France flouted the Stability and Growth Pact rules), and then the GFC.

The average quarterly growth rate between June 2003 and the GDP peak in September 2007 was 0.4 per cent. If we extrapolate the real GDP series from that peak at that trend growth rate we get a graph like this, which shows the extended trend and the actual real GDP.

The gap between the extrapolated trend and actual, as at June 2014 is around 17 per cent. That means that if the Italian economy had have kept growing at that steady 0.4 per cent per quarter without the GFC and austerity interruptions, then it would be 17 per cent larger than it is now. That is a huge output gap and suggests there is massive scope for domestic fiscal expansion.

With the lengthy recession and decline in investment, it is highly likely that the red line is fictional and the potential GDP is somewhere below it, which just goes to show that the damage of the self-imposed austerity is greater than the lost current output and income.

In 1995, Reuters reported the Italian Labour and Welfare Minister Roberto Maroni as saying that Italy:

… should consider leaving the single currency and reintroducing the lira … [the euro was a] … disaster … [and] … has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis … [he said that Italy should] …. to give control over the exchange rate back to the government …

It is a pity for the Italian workers and workers elsewhere in Europe that the Italian government didn’t take his advice.

It is also a pity that common sense came out of a right-wing nationalist (he is associated with the Lega Nord party) although the party is not easily stereotyped.

The most responsible strategy for Europe when the crisis hit, especially given its severity and the particular exposure of some European economies and banks, would have been for the Council to immediately suspend the SGP provisions and for the ECB to announce that they would support all necessary fiscal deficits to offset the private spending collapse.

The former decision could have been justified under the ‘exceptional and temporary’ circumstances provision of Article 126 of the TFEU relating to the EDP. It was clear that the situation was ‘exceptional’ and with appropriate policy action would have been ‘temporary’.

The Council had already demonstrated a considerable propensity to bend its own rules. The ECB could have immediately announced a program such as the Securities Markets Program (SMP) whereby they promised to buy up unlimited volumes of national government debt in the secondary markets.

If the SMP had been introduced in 2008 rather than 2010 and without the conditional austerity attached, things would have been much different.

No Treaty change would have been required for either of these ad hoc arrangements to be put in place.

While obviously inconsistent with the European Groupthink, these policy responses would have saved the Eurozone from the worst.

Fiscal deficits and public debt levels would have been much higher but, in return, there would have been minimal output and employment losses and private sector confidence would have returned fairly quickly. The response of the private bond markets would have been irrelevant.

The European policy makers did exactly the opposite and guaranteed the economic collapse would be deeper and longer than otherwise.

In a recent blog – Italy should lead the way out of the euro-zone – I concluded that the ECB should immediately introduce so-called – Overt Monetary Financiing – to facilitate a major increase in fiscal deficits without any further increase in public debt.

I would go further. The ECB should purchase all outstanding public debt in Europe and write-it off – that is, with a stroke of the keyboard delete it as an asset on its books. The capital loss would be immaterial as it issues the currency.

The Council should also scrap the Stability and Growth Pact and all its current incarnations (Fiscal Compact, 6 and 2-packs, etc). Instead, it should request nations submit plans for how they are going to achieve full employment and support those plans. End austerity, stimulate growth.

Dreaming!

Given the reality though, it is clear that the best thing for Italy to do is follow Roberto Maroni’s advice and exit the Eurozone.

Italy should use its place as third-largest economy in Europe to provide the exit blueprint that other Eurozone nations can follow without being bullied by the Troika.

Its intention to exit could not be ignored by the technocrats and conservatives. It could force Brussels to negotiate sensible redenomination rules to avoid lengthy legal challenges and it could immediately set about reversing the growth situation.

The decline in the second-quarter 2014 was mostly because exports have fallen. But with its own currency, it could rely on domestic spending growth for a return to stronger employment growth and lower unemployment.

It would not only restore its own prosperity but help the smaller nations like Greece, Portugal and Spain see a better path.

Conclusion

By restoring its own central bank functions, Italy could expand its fiscal deficit (targetted at job creation programs) and instruct the central bank to just credit bank accounts to facilitate this spending. That is, allow Overt Monetary Finance to accompany the fiscal stimulus.

It could ignore the ECB and the Troika, and redenominate all outstanding public debt in lira. No further public debt would need to be issued. The Banca d’Italia could progressively buy up all the outstanding debt and write it off.

The bond markets would have no influence on any of the future developments given the restoration of currency sovereignty and the OMF strategy of the government and its central bank.

My Eurozone book outlines in considerable detail how this exit strategy can work.

I urge progressive Italian politicians to introduce as their central mandate an exit plan.

That is enough for today!