It’s Frankfurt that should be your worry – not Rome

This week investors have been spooked by the election outcome in Italy, but frankly speaking is there anything new in that shady characters are doing well in an Italian election? Is there anything new in a hung parliament in Italy? Nope, judging from post-WWII Italian political history this is completely normal. Ok, Italian public finances is a mess, but again that not really news either.

So if all this is ‘business-as-usual’ why are investors suddenly so worried? My explanation would be that investors are not really worrying about what is going on in Rome, but rather about what is going on in Frankfurt.

Last year I argued that the ECB had introduced ‘political outcomes’ in its reaction function:

This particularly is the case in the euro zone where the ECB now openly is “sharing” the central bank’s view on all kind of policy matters – such as fiscal policy, bank regulation, “structural reforms” and even matters of closer European political integration. Furthermore, the ECB has quite openly said that it will make monetary policy decisions conditional on the “right” policies being implemented. It is for example clear that the ECB have indicated that it will not ease monetary policy (enough) unless the Greek government and the Spanish government will “deliver” on certain fiscal targets. So if Spanish fiscal policy is not “tight enough” for the liking of the ECB the ECB will not force down NGDP in the euro zone and as a result increase the funding problems of countries such as Spain. The ECB is open about this. The ECB call it to use “market forces” to convince governments to implement fiscal tightening. It of course has nothing to do with market forces. It is rather about manipulating market expectations to achieve a certain political outcome.

Said in another way the ECB has basically announced that it does not only have an inflation target, but also that certain political outcomes is part of its reaction function. This obviously mean that forward looking financial markets increasingly will act on political news as political news will have an impact of future monetary policy decisions from the ECB.

And this is really what concerns investors. The logic is that a ‘bad’ political outcome in Italy will lead the ECB to become more hawkish and effectively tighten monetary conditions by signaling that the ECB is not happy about the ‘outcome’ in Italy and therefore will not ease monetary policy going forward even if economic conditions would dictate that. This is exactly what happened in 2011-12 in the euro zone, where the political ‘outcomes’ in Greece, Italy and Spain clearly caused the ECB to become more hawkish.

The problems with introducing political outcomes into the monetary reaction function are obvious – or as I wrote last year:

Imaging a central bank say that it will triple the money supply if candidate A wins the presidential elections (due to his very sound fiscal policy ideas), but will cut in halve the money supply if candidate B wins (because he is a irresponsible bastard). This will automatically ensure that the opinion polls will determine monetary policy. If the opinion polls shows that candidate A will win then that will effectively be monetary easing as the market will start to price in future monetary policy easing. Hence, by announce that political outcomes is part of its reaction function will politics will make monetary policy endogenous. The ECB of course is operating a less extreme version of this set-up. Hence, it is for example very clear that the ECB’s monetary policy decisions in the coming months will dependent on the outcome of the Greek elections and on the Spanish government’s fiscal policy decisions.

The problem of course is that politics is highly unpredictable and as a result monetary policy becomes highly unpredictable and financial market volatility therefore is likely to increase dramatically. This of course is what has happened over the past year in Europe.

Furthermore, the political outcome also crucially dependents on the economic outcome. It is for example pretty clear that you would not have neo-nazis and Stalinists in the Greek parliament if the economy were doing well. Hence, there is a feedback from monetary policy to politics and back to monetary policy. This makes for a highly volatile financial environment.  In fact it is hard to see how you can achieve any form of financial or economic stability if central banks instead of targeting only nominal variables start to target political outcomes.

Therefore investors are likely to watch comments from the ECB on the Italian elections as closely as the daily political show in Rome. However, there might be reasons to be less worried now than in 2011-12. The reason is not Europe, but rather what has been happening with US and Japanese monetary policy since August-September last year.

Hence, with the Fed effective operating the Bernanke-Evans rule and the Bank of Japan having introduced a 2% inflation target these two central banks effective have promised to offset any negative spill-over to aggregate demand from the euro zone to the US and the Japanese economy (this is basically the international financial version of the Sumner Critique – there is no global spill-over if the central banks have proper nominal targets).

Hence, if Italian political jitters spark financial jitters that threaten to push up US unemployment then the Fed will “automatically” step up monetary easing to offset the shock and investors should full well understand that. Hence, the Bernanke-Evans rule and the BoJ’s new inflation target are effective backstops that reduces the risk of spill-over from Italy to the global markets and the global economy.

However, investors obviously still worry about the possible reaction from the ECB. If the ECB – and European policy makers in general – uses political events in Italy to tighten monetary conditions then we are likely to see more unrest in the European markets. Hence, the ECB can end market worries over Italy today by simply stating that the ECB naturally will act to offset any spill-over from Italy to the wider European markets that threatens nominal stability in the euro zone.

Related posts:
News of Berlusconi once again slipped into the financial section
Spanish and Italian political news slipped into the financial section
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
“…political news kept slipping into the financial section”

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Spanish and Italian political news slipped into the financial section

One of my favourite Scott Sumner blog posts is on the connection been monetary policy failure and the impact of political news on the financial markets. I have quoted Scott many times on this issue, but let me do it again:

I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They knew that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

And the worst part was the way political news kept slipping into the financial section.  Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc.  In the 1930s the readers didn’t know what came next—but I did.

It has been a long time since political headlines really have been able to move the global financial markets (remember the fiscal cliff story never really did it). However, just take a look at these two stories from today:

 Ten-year Spanish government bond yields rose on Monday as the country’s opposition party called for the resignation of Prime Minister Mariano Rajoy over a corruption scandal.

…and here:

Ten-year Italian government bond yields also rose on concerns that a scandal involving Monte Paschi bank could see a rise in the popularity of the centre-right party in the polls, whose election charge is being led by former prime minister Silvio Berlusconi.

Since August-September the Federal Reserve and the Bank of Japan the have moved in the direction of easing monetary policy and a significantly more ruled basked monetary policy and even the ECB has eased up with ECB chief Draghi’s promising to do “whatever it takes” to save the euro. And Mark Carney has given investors hope that the Bank of England will move towards some form of NGDP level targeting. As a result the “euro crisis” has more or less disappeared from the headlines in the newspapers’ “financial section” (just take a look at what Google trends has to say).

Hence, it seems pretty clear that the markets’ “responsiveness” to political worries is a function of the tightness of global monetary conditions with tighter monetary conditions leading to a bigger impact of political jitters.

So where are we now? It to me all dependent on the ECB. If the ECB move towards a clearly rule based regime – in a similar fashion as the Fed and the BoE (and likely soon also the Bank of England) then we are likely to see markets becoming more immune to political jitters. On the other hand if the ECB moves back to the bad habit of conditioning monetary policy on political outcome then once again the markets will start worrying about the finer details of Italian and Spanish politics.

PS Some would argue that European monetary conditions have become tighter recently as a result of higher money market rates and yields. However, I don’t think that is the case. Higher yields and rates reflect growth optimism – just look at European stock markets and implied inflation expectations in the European fixed income markets. Market Monetarists don’t run for the door in panic when yields rise – rather we argue that you should not make the interest rate fallacy and confuse higher (lower) rates/yields with tighter (easier) monetary policy. As Milton Friedman reminds us rates and yields are high (low) when monetary policy has been easy (tight).

The reason Mario Monti is beginning to sound (very) desperate

When the eurocrat Mario Monti became Prime Minister last year we were told that he was the man to turn around the Italian economy. We were told that technocrats would do the job rotten and incompetent politicians were not able to do. However, the eurocrat Papademos did not last long in Greece and now Mario Monti is beginning to sound rather desperate. On Thursday he told reporters that EU policy makers had one week to save the euro. That is somewhat of a stern warning from somebody who is supposed to be a cool-headed technocrat.

Why this sudden desperation from Monti? Well, it is pretty simple – Italian nominal GDP is declining sharply, while Italian funding costs are increasing sharply day-by-day. With NGDP declining rapidly the public debt-to-GDP ratio obviously is exploding and as investors know that the ECB has not shown any willingness to curb the decline in NGDP then Italian debt as share of GDP is likely to continue to increase no matter how many budget cuts and tax increases the Italian parliament passes. It is very simply – without growth in NGDP the Italian government will fast become insolvent.

Therefore, it is not really Angela Merkel Mario Monti should be asking for help to solve the crisis, but rather his namesake and countryman ECB chief Mario Draghi. The ECB can end this crisis by introducing a determined policy to curb the drop in euro zone NGDP (or rather to increase NGDP markedly). On the other hand if Draghi does not act then it might very well be that Monti is right about his warnings.

PS Meanwhile Monti’s predecessor is having other ideas (remember Italy never defaults – Italy inflates…) and it is not the first time.

A history of bunganomics

Market attention has changed from Greece to Italy. As in Greece the centre of attention is the dual concerns of public finance trouble and political uncertainty.

A look at Italian economic and monetary history, however, reveals some interesting facts. While Greece is a serial defaulter Italy has in fact only defaulted on it’s public debt one time since Italy become an independent and unified nation in 1861. Contrary to this Greece has been in default in more than 50% of the time since it became an independent nation in 1822 (1830).

Minimal knowledge of Italian history will teach you that the country is notorious unstable politically and that public finance trouble historically as been as much a norm as in Greece so how come that the Italian government has not defaulted more than once?

Some Unpleasant Monetarist Arithmetic will help us explain that. Sargent and Wallace teach us that public deficits can be financed by either issuing public debt or by printing money. Historically Italian governments have had a clear affinity for printing money.

Rogoff’s and Reinhardt’s “This Time is Different” provides us with the statistics on this. Hence, among the present euro countries Italy has been the third most inflation-prone country historically – after Austria and Greece. Hence, since 1800 Italy has had inflation above 20% in more than 11% of the time. The similar numbers for Austria and Greece are 20% and 13% respectively.

Michele Fratianni, Franco Spinelli and Anna J. Schwartz have written the “Monetary History of Italy” and the authors reach the same conclusion – that the core of Italy’s inflationary problems is the Italian government’s lack of ability to balance the budget.

This time around the money printing option is not easily available – at least not if the Italian government wants to keep Italy in the euro zone. Sargent and Wallace would tell us to watch inflation expectations to see whether the Italian government is credible or not when it says it will not leave the euro.


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