The little coin that could

 

 

The concept that the Euro as a single currency has been THE problem that doomed Italy to decades of stagnation might be an attractive concept, but my opinion is that this is a typical case of “post hoc ergo propter hoc”. 

 

We're approaching August, and in late August 1988 I started working in a fund management company in Italy. So I am approaching 35 years in the business.

Since I immediately engaged in foreign investment for an Italian fund, I was acutely aware of the currency risks involved in that part of the business. Yes, for my position devaluations were a sort of a bonus ball (all positions held abruptly rose in domestic currency terms), but having lived through that period and the whole life of the Euro currency so far, I hold opinions which are different from mainstream.

So when I saw this post on X by Michael Arouet, I felt compelled to shove my oar in:

 

Notice that the first sentence is factual (duh) and that I agree also on the second. Where I differ is what part the single currency per se played in the erosion of my country, and my opinion is that the answer is “very little”.

This might seem counterintuitive, and by all means, I WANT pushback if it advances knowledge, so hear me out, and tell me if what I write makes sense.

In my opinion, Devaluations in the period preceeding the EUR were a consequence, not a cause of the periodic lapses in the ability of italian industry to remain competitive, and they were cathartic events that periodically wrested back economic power from governments back to the private INDUSTRIAL sector. A rough description of the loop according to conventional wisdom is this:

• Italy's total factor productivity gets eroded by wage increases, additional regulation and taxation, unproductive public spending etc;

• that causes an increase in external deficit due to import/export imbalances (mainly energy, since Italy has no natural resources );

• This puts pressure on government bond rates AND the currency exchange rate, which at least for a while authorities try to compensate by hiking rates;

• at some point the rubber band breaks (in the periods when there IS a rubber band, remember the ECU and the ERM) and there is a sudden adjustment called “devaluation”. This tough is a time compression effect.

• After a period of increased domestic competitivity on tradeable good and increased tax revenues due to a recovery in economic activity, the loop restarts.

One of the consequences of that system was that rates in Italy were calibrated by domestic and international investors on THAT kind of expected outcome, hence very little financial investment from abroad went into Italian public debt, and domestic savers were well paid to be the lender of last resort. Because mind you, they WERE in any case, either through inflationary bouts following money printing periods, or through the fiscal lever etc.

BUT, the remuneration grosso modo followed a market adjustment mechanism. And the EUR didn't at all have to remove that per se: only the CURRENCY adjustment went AWOL, but there were (and are) other ways. Look at this graph here:

 

This is the German 2 year Government bond rate over time, and it encompasses almost the whole period. See that initial rate?

That's over 9 percent. Why? Did Germans went on a Potlatch and squandered trillions of Dmarks?

No, what happened was the fall of the Berlin Wall, and the subsequent fall of the Soviet Empire (whose remnants occupy the mind of a Russian who had to flee in order to escape the newly freed East Germans... his name was Vladimir Putin). Germany and East Germany merged, and there was a question of deciding at what exchange rate the former East German currency would be converted. Given the productivity differences, the Orthodox Bundesbank was pressing for something similar to One Dmark = two East German Marks.

Politics prevailed and the exchange was fixed at one to one. In an ironic twist of fate, basically West Germany DEVALUED against East Germany, with all the attendant distorsions... Which the almost monastic Bundesbank controlled by having rates rise quickly to a level that would make all present day ECB personnel, INCLUDING MODERN DAY Germans, faint for hours.

So you see, it IS not only possible to withstand a fixed exchange rate, but it WAS done, and ultimately the outcome worked surprisingly well. Interest rates, both those set by the Bundesbank and the long term ones set by the markets, worked to guide the economy on a righteous path. Eventually long term rates began to fall, signaling that the excess liquidity had been sterilized and the economy wasn't on an inflationary path any more, and policy returned to normal... which was about 5~6% long term rates.

So what went wrong when a similar thing happened Europewide, and with the BuBa as one of the participating central banks to boot? Let's see …. but for that you will have to pass a small one – question test: a big increase in supply, all else being equal, should cause the price of any good rise or fall?

 

This graph is Italian debt/gdp compared with Italian long term government bond rates. What happened to cause a FALL in rates (translation: all else being equal government bond prices go UP) in the face of a BIG increase in the supply of such debt?

The answer is quite simple: the real father of the ECB being Bank of Italy, or rather “not the Bundesbank”, both the charter and the culture of the single central bank allowed it to start a debt monetization program the likes of which humanity hadn't seen on the continent in its entire history, a.k.a. “Quantitative Easing”. Also, bear in mind that the mission picks the men, not the other way around: the lack of self criticism on the part of financial authorities borders on the pathetic, but that was to be expected since those kind of postings will never attract steeled people who will say “no” to politicians. As I said, not in the mission statement.

The ECB quickly racked up 80% of GDP in financial assets, and even the Google SEARCH is interesting, as exemplified by the top result:

 

This is a wonderful “there's nothing to see here” results, which for once makes me yearn for adding a public full time servant: the ECB needs a social media manager. Because if someone less easily fobbed off look into the site and goes to the actual accounts, this is what he/she will get:

 

So that first figure is correct.... if you divide the real figure by ten. The ECB held at year end a bit less than 5 trillion EUR in securities, and its total assets were a bit less than 7 trillions.

I would surmise that given that Italy's GDP is in the region of 2 trillion, ECB committee minutes should introduce the concept of “one Italy” in describing financial policy increments. But I digress... and it's not material. You see, Italy as well let its debt AND debt/GDP grow during the pre EUR era, but it was politically impossible to enact this levels of monetization without triggering huge imbalances... and especially it was more difficult to hide the “simplified model”: that shopping spree would have done two things, repressing rates by lowering debt cost (for government) for issuance and raising inflation by making consumption more palatable than saving. The ECB was spared that by disinflation caused basically by China. So yes, in essence the politicians/ central bankers combine DID export “jobs” to cover for their monetary policy blurbs.

There is an added paradox here, related to the latest “let's conceal some more debt increase”, which is the push to introduce an EU common debt instrument. That's a more delicate grounds than lay persons would know: think about the European Investment Bank, who routinely issued bonds to finance its infrastructure spending projects. That's an example of EU bond for most people.... since they do not know the meaning of the legal expression “jointly and severally” attached to the member governments guarantees.

That expression makes southern comfort countries salivate and old school German financial hands recoil in horror. It basically means that ALL countries are responsible for paying ALL the debt fo the EIB, insofar if one country went under or was in any shape or form unable to finance its share, the hole would have to be covered by the remaining solvent debtors. So the TL:DR version is “ the only shoulders that count are the ones of the best managed big country”.

At this point all players quote “Band of Brothers” and say “that dog just ain't gonna hunt”. So different solutions are aired.. my point is that the situation would have been much better had Europe STARTED by enacting a common debt issuance (or failing to, so back to the drawing board it would have been) that a common currency. Yes, a common currency is easier to sell to a bloke in Grenoble or Blankenheim, NRW, the latter being less than two hours drive to four national borders and currencies... but was the abandonment of MARKET discipline of public finance a worthy price to pay? I did some musings on common EU debt and it is indeed much harder to design and implement than lay people would expect.

There have been attempts at Ersatz limits to politicians going hog wild with cheap money, like the debt brake etc., see here: https://commission.europa.eu/business-economy-euro/economic-and-fiscal-governance/european-fiscal-board-efb/compliance-tracker_en

That was “cute”, in that interest rate repression not only shifts resources from private savers to public spenders, but it also changes the composition: interest rate being the cost of time in term of money, its repression “bends” the order of preference of spending towards more uncertain and long term dubious efforts, hence the plethora of initiatives that end with a “target year” which is at least 10 year in the future. And that is an even more intractable problem to solve since it involves “personnel” decisions, i.e. Governments going back on those efforts would have to actually, you know, FIRE people.

Now don't get me wrong, I am not surmising we are governed by an evil clique bent on destroying mankind: rather, that the combination of easy money and lack of direct security threats after the fall of the Berlin Wall built the period where “weak men create hard times.”

So any reference to “hawkish central bankers” should be put into perspective, because our reality shifted radically in the last two decades. The most hawkish of them, interviewing with the late Bundesbank, would probably have been booted out as far as Mainz. I feel for them because a reversal of policy, IN TERMS OF MAGNITUDE is simply too gut wrenching to contemplate.... but my pinned tweet remains “Kicking the can doesn't stop when you reach the wall. It stops when you break your toes."