By Charles Gave, 12/21/16
ALG Editor’s Note: In the following
featured analysis from Mauldin Economics (h/t Zerohedge), Charles Gave warns that a
massive sovereign default could be looming in Italy:
Matteo
Renzi has joined a long line of Italian prime ministers who failed to “reform”
their country. This is another way of saying
that he could not wave a magic wand and make Italy competitive with Germany.
The grim reality is that no Italian leader stood a chance of changing their
country once the fateful decision was made to peg its currency to Germany’s. At
the time of the euro’s launch in 1999, I argued that the risk profile of Italy
would change from being an economy where there was a high probability of many
currency devaluations to the certain probability of eventual bankruptcy. Sadly, that moment is not so far away.
The chart
below tells the story of Italy’s recent economic history in two parts, namely, (i) March 1979 to March 1999, and (ii) March
1999 to the present. Italy joined the Exchange Rate Mechanism in 1979 at 443
lira per deutschemark, yet by 1990 frequent devaluations meant that rate had
slid to about 750 lira. By the early 1990s, the Bundesbank was overseeing a
newly unified German monetary system and in order to fight inflation it had
driven real interest rates to 7 percent. By September 1992 the stresses on the
system caused the UK, Sweden and Italy to exit the ERM, which meant another
huge currency devaluation, pushing the lira as low as 1250 against the
deutschemark, but delivering a huge tourist boom to boot.
Still, from 1979 to 1998 Italian industrial production outpaced that of Germany
by more than 10 percent, while Italian equities outperformed German equivalents
by 16 percent (this indicates that Italian firms were earning a
higher return on invested capital than those in Germany).
Then came
the euro. By 2003 it was clear that
Italy was uncompetitive and subsequently, Italian equities have underperformed
German equities by -65 percent, reversing the previous half century’s pattern
when Italian equities outperformed on a total return basis. Similarly, since 2003 Italian factory output
has lagged Germany’s by 40 percent.
The
diagnosis is simply that Italy has become woefully uncompetitive, and as a
result, is not solvent. This much is
clear from the perilous state of its banking system, which is always the
outcome when banks lend to firms that have been rendered uncompetitive by some
reckless central banker. Short of imposing Greek-style slavery on Italy, there
is not much hope of solving the problem, but I rather doubt that the Italian
electorate will be as patient as its neighbours across the Ionian sea.
As such, the relationship between Italy and Germany is radically different
from that in the 1945-99 era when a natural return toward equilibrium was
achieved through exchange rates adjustments. The only possibility on the
current trajectory is that the Italian and German economies keep diverging,
which is why a “normal” resolution cannot be achieved.
Hence, an Italian sovereign default
of some variety is now a near certainty. While a central bank can address a
liquidity problem, it cannot fix a solvency issue, especially one as large as
Italy’s. The only remedial action that can now be taken is to throw good money
after bad, which is exactly what I expect Mario Draghi to do, especially as he
played such a key facilitators’ role in getting Italy into the euro system in
the first place. Such actions – possibly to be announced on Thursday at the
European Central Bank’s policy setting meeting – can of course merely postpone
the day of reckoning, but will solve absolutely nothing. Get full story here.
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