Europe

The world has just experienced a watershed year for populist politics, with antiestablishment challengers winning elections and illiberal regimes modeling an alternative, says expert Yascha Mounk.

The defeat of Italian Prime Minister Matteo Renzi’s constitutional reforms is another sign that voter anger over poor economic performance is driving anti-establishment politics across Europe, says CFR’s Sebastian Mallaby.

The post-referendum market response to Italy’s referendum mirrored the reaction following the Brexit and U.S. election votes: calm after a knee-jerk negative reaction.  After all, not much has changed—Prime Minister Renzi stays on in a caretaker role (perhaps through end year), after which it is expected a new government with similar political orientation would take over with a rather narrow mandate to pursue a revised constitutional reform plan, address critical governing issues such as migration, and complete a fix of the banks. Most market participants do not expect snap new elections. Italy today in this sense does not look much different than it did yesterday. The fact that tail risks have been avoided this time is heartening. It in part reflects confidence in the European Central Bank (ECB), which is expected to extend quantitative easing this week and could consider other measures (such as advancing purchases) to support Italian bonds should market spreads come under pressure.  Tail risks are by definition unlikely but dramatic if they occur, and sometimes they do. Like the Brexit rebound, today’s market calm doesn’t reduce my concern about the economic risks going forward. The central economic risks facing Italy today are the same as before—banks and growth. Efforts to recapitalize the Italian bank Monte dei Paschi di Siena (MPS) now look in danger of collapse, as heightened political uncertainty may undermine investor’s willingness to back a €5 billion bank recapitalization plan strongly supported by Prime Minister Renzi. If so, a defacto nationalization by the government is likely required.  MPS’s problems by themselves are not a systemic risk for Europe, but they are a bellwether for broader risks facing an undercapitalized and barely profitable Italian banking sector that, collectively, is systemic.  Under new European Union (EU) banking rules, Italian banks need to recapitalize by end year, and the risks of a broader shortfall are now significant (most importantly, if market turmoil undermines efforts by Unicredit, Italy’s largest bank, to complete its €13 billion capital raising effort).  Europe should consider extending that deadline, or otherwise creating additional leeway for state support, as a broader bail-in of private bank creditors, if required under the rules, would be destabilizing in the current unsettled environment. All this occurs against the backdrop of incomplete monetary and financial union. It is almost cliché to argue that the current state of economic and financial integration is unsustainable—Europe must move forward or back, but can’t stand still. For now, easy money from the ECB enforces a quiet stability, and bond spreads for Italian banks (and for the government as well) remain quite low, but they are vulnerable to spiking higher. Still, with the ECB buying program in place it may be news flow about recapitalization and stock prices, rather than government bond spreads, that could be the leading indicator of an emerging banking crisis. Banks without adequate capital don’t lend, and that means that perhaps the most significant legacy of the current vote is a continued headwind to anemic Italian growth.  Unemployment likely will remain sky high, and disaffection with the current mainstream (and pro-EU) policies is likely to remain similarly high. That means that Italy remains an economic risk—perhaps the most significant one—for the future of the euro and Europe.  There may also be broader spillover effects—notably in hardening views in Germany and other creditor countries towards debt relief and an International Monetary Fund deal for Greece—but the euro can survive Grexit.  Italy is another matter.

Italy’s vote on constitutional reforms, which may determine whether the country can escape its economic doldrums and rescue its ailing banking system, could have consequences for all of Europe, says CFR’s Robert Kahn.

This is not a post about China, or the various discrepancies in the Chinese data. It is about a rather puzzling thing that I only noticed as a result of the Brexit debate. The bulk of the UK’s surplus in services come from trade with non-EU countries (services exports to the EU are large, but so are imports—Tuscan and French vacations?). See this chart (h/t Toby Nangle). A big part of the non-EU surplus in services comes from the United States. In 2015, the UK reported a 27 billion GBP (just over $40 billion) surplus in services trade with the U.S. and an overall surplus in goods and services with the United States. The funny thing? The U.S. also thinks it runs a surplus in services trade with the UK. A $14 billion surplus in 2015, for example. It is pretty hard to square those two data points. UK data is from the Office of National Statistics’ Pink Book, U.S. data is from the Bureau of Economic Analysis (BEA), table 1.3 of the "International Transactions" data set. It turns out that the U.S. thinks it sells more services to the UK than the UK thinks it buys: And the UK thinks it sells more services to the U.S. than the U.S. thinks it buys. My guess is that such discrepancies are actually common in the services trade numbers. Goods trade is calculated by customs bureaus. Lots of the numbers on services trade come from surveys, estimates, and the like.

The Wall Street Journal, building on a point made by Peterson’s Jacob Kirkegaard, seems convinced that the policy mood has shifted, and Europe is now poised to use fiscal policy to support its recovery. I, of course, would welcome such a shift. The eurozone runs an external surplus, is operating below potential (in large part because of a premature turn to austerity in 2010 that led to a double-dip recession) and in aggregate has ample fiscal space. And the public policy case for such a fiscal turn keeps getting stonger. Jan in ’t Veld’s new paper (hat tip Paul Hannon of the WSJ) suggests that a sustained fiscal expansion in Germany and the Netherlands could have a substantial impact on the rest of the eurozone. A sustained 1 percent of GDP increase in public investment in Germany and the Netherlands helps raise output and lower debt in their eurozone partners.* in ’t Veld writes: "Spillovers to the rest of the eurozone are significant ... GDP in the rest of the eurozone is around 0.5% higher." But it seems a bit too early to break out the champagne. Actual 2017 fiscal policy has not been set in the key countries, but it is not clear to me that the sum of the fiscal decisions of the main eurozone countries will result in a significant fiscal expansion across the eurozone. Indeed, I cannot even rule out a small net consolidation. Germany has put forward its 2017 budget. Schauble’s rhetoric has changed a bit. But Citibank estimates that it only would reduce Germany’s structural fiscal surplus by about 0.1 percent of GDP (10 basis points of GDP). It is a step in right direction, but only a baby step. Real loosening doesn’t seem on the cards before 2018. I do not think the Dutch have put forward their 2017 budget. But their 2016 stability report suggests that they are aiming for a structural fiscal consolidation of about 0.3 percent of GDP. They still want to bring their structural deficit down to around one percent of GDP. The French would likely need to do a bit of consolidation if they still intend to get their 2017 fiscal deficit under 3 percent of GDP, but I will grant that Hollande is likely to get a bit of flexibility heading into the election. Renzi would certainly like to provide a fiscal jolt to Italy’s economy. But the pressure on the Italians from the Commission and others is still to consolidate. Rules and all. The Commission’s target for Italy’s fiscal deficit in 2017 is 1.8% of GDP. I doubt Italy will do the consolidation that would be required to get the deficit under 2 percent of GDP, but I also am not convinced that Italy will be given space to loosen. The battle lines have been drawn up, but the actual battle has not yet been fought. If the impact of the Dutch consolidation is offset by the modest German expansion, and if France and Italy end up with a fiscal stance that is roughly unchanged, Spain becomes the wild card that could determine the eurozone’s overall fiscal stance. And, well, there seems to be a risk that in the absence of government, Spain’s spending will be held constant in nominal terms – resulting in a meaningful consolidation. HSBC’s Fabio Balboni: “If the 2017 budget cannot be approved by the end of the year, all of the main spending items will be frozen at current levels, including wages and pensions. That would be equal to spending cuts of about 1% of GDP. This might help to reduce the deficit, but it would also have negative consequences for growth.” Even if Spain forms a government that avoids sequester style cuts, it will face pressure to bring its deficit down. Daniele Antonucci of Morgan Stanley: “Spain will tighten the belt ... the question mark is to what degree, and that also depends on the political situation.” Bottom line: If Spain – which has the largest deficit of any of the eurozone’s main economies – ends up doing a significant consolidation, whether as a result of the absence of a government or as a result of a conscious decision by the Europeans to push Spain to move closer to its targets after it elects a new government, someone else has to do an actual expansion to keep the eurozone’s overall fiscal stance neutral. Best I can tell, Germany 2017 budget won’t do the trick. And until the 2017 budgets for France and Italy get approved, we won’t know if they will be able to offset a likely tightening in Spain. * Jan in ’t Veld’s paper assumes the fiscal stimulus is not offset by monetary policy in the first two years, and the euro initially depreciates. His argument is thus a bit different than the argument made by the IMF in its external stability report, as the IMF was looking at fiscal expansion in surplus countries as a partial offset for monetary expansion. ** I suspect Japan’s fiscal stance has changed more than Europe’s fiscal stance. But I would like to confirm that the new stimulus will do more than offset the roll-off of past stimulus packages. If anyone reading this has a good estimate of Japan’s actual fiscal stance, please do let me know. Japan has carried out a meaningful fiscal consolidation over the past three years -- with more consolidation than implied by the rise in the consumption tax.

Back in May, Greg Ip of the Wall Street Journal argued that Germany didn’t need to stimulate its economy through an increase in public investment as its economy was already growing at a decent clip, and unemployment was low. I wasn’t convinced then, and I am still not convinced. A stimulus is needed to reorient Germany’s economy away from exports, to keep private wage growth up and to open up space for Germany’s trade partners in the euro area to adjust without falling into a deflationary trap. Adjustment doesn’t happen magically. There is solid evidence that Germany’s level of public investment is a bit too low for its long-term health. And now there is also a growing cyclical case for a German stimulus. German growth is projected to slow significantly in 2017. Reuters reports: "DIW ... lowered its 2017 growth forecast for Germany to 1.0 percent from 1.4 percent." Other forecasts are a bit more optimistic, but all expect some slowdown in growth. And the 2016 surplus is on track to top a percentage point of German GDP. In nominal terms, the surplus should exceed last years’s €30 billion surplus. Germany is clearly not fiscally constrained. So rather than growing at 1% in 2017 and running a fiscal surplus of 1% of GDP, as now seems likely, Germany could choose to do a quick-hitting stimulus and likely pull growth up toward 2%. Some of those funds could support a rise in public investment that would likely raise future growth. And in the process of helping itself Germany would also help the world, as a fiscal expansion would help to bring down the world’s largest external surplus (China’s surplus has fallen a bit this year, Germany is poised to regain the top spot). This really shouldn’t be hard. It doesn’t require abandoning the schwarze Null (black zero), as Germany now needs to tax less or spend more if wants to be in fiscal balance. It does require a deal within Germany’s governing grand coalition on the right split between spending and tax cuts ahead of next year’s election. The actual fiscal loosening in the current 2017 budget seems very modest; Citi recently estimated that it might reduce the structural fiscal surplus by about 0.1% of GDP. Not much, in other words. Talk of tax cuts after the October German election isn’t enough; it doesn’t change the 2017 fiscal stance.

The Economist, inspired in part by a recent paper by Caballero, Farhi and Gourinchas, highlighted two key points in its free exchange column criticizing Germany’s surplus: a) Global imbalances have reemerged over the last few years (though this is more obvious from summing the surpluses of surplus countries than from summing the deficits of deficit countries): "... a sustained era of balanced growth failed to emerge [after the global crisis]. Instead, surpluses in China and Japan rebounded. In recent years Europe has followed, thanks to a big switch from borrowing to saving." b) Those imbalances are a big reason why interest rates globally are low: "Once a few economies become stuck in the zero-rate trap, their current-account surpluses exert a pull which threatens to drag in everyone else." I have only one small quibble. The rise in Asia’s surplus didn’t just come immediately after the crisis. There was also a significant rise in Asia’s surplus from 2013 to 2015. Indeed, in 2015, East Asia’s combined surplus actually significantly exceeded that of Europe, adding to the world’s difficulty generating enough demand growth even with ultra-low rates.* Yes, some of this is oil. But the oil exporters in aggregate aren’t running large external deficits financed by their high saving customers (Russia is in surplus; the Saudis are more an exception than the rule). The IMF puts the aggregate deficit of the main oil exporting regions of the world economy (the Middle East, North Africa, Russia and Central Asia) at $50-100 billion, substantially less than the combined surplus of Europe and Asia. So it isn’t all oil either. China’s unloved, credit-based stimulus, together with the large reported increase in tourism spending (whether real or fake), looks set to pull China’s surplus down a bit in 2016. But China will retain a surplus of over $200 billion in 2016, and ongoing surpluses in Korea, Taiwan, Singapore and Japan will keep Asia’s aggregate surplus high. I would bet East Asia’s aggregate 2016 surplus will still exceed that of Europe. There is one additional important difference between the imbalances of the pre-crisis global economy, and today’s imbalances. Large global imbalances prior to the global crisis came from the combination of large surpluses in Asia and the major commodity exporters—a strange combination, if you think that surpluses (deficits) in oil exporters and deficits (surpluses) in oil importers should trade off. And in both the oil exporters and in Asia, those surpluses were sustained in large part by official outflows (i.e. from governments and central banks). Private flows on net wanted to go into fast growing Asian economies, not run away from them. The puzzle in some sense was why the U.S. attracted large inflows despite having slower growth and often lower interest rates than many major surplus economies. Today’s surpluses by contrast are predominantly in countries with negative or low interest rates, and thus the flows that support today’s imbalances are mostly private. The euro area, Denmark, Sweden, Switzerland and Japan all have negative interest rates. China isn’t at the zero bound, so in some sense it is the exception. Yet so long as its currency is drifting down there is an incentive for private funds to flee. Korea is another exception, I guess, as it maintains positive interest rates. But it is cutting rates, and it also sustains its surplus in part through intervention. The best outcome for the world, as George Magnus notes, would be a surge in internal demand in one of the main surplus countries that gives the entire global economy a lift, and helps pull up nominal rates globally. In the Caballero, Farhi and Gourinchas model, monetary expansion by a surplus economy stuck at the zero bound risks exporting its liquidity trap, and pulling other countries into liquidity traps of their own. Fiscal expansion, by contrast, has positive global spillovers. But for now, that doesn’t seem to be happening, despite a few somewhat encouraging noises from the G-20. Not in Germany. And not in many of the key countries in Asia, with the possible exception of Japan. And one of the most obvious risks facing the global economy is that demand growth in one of the main surplus countries could falter. China’s unusually high level of investment over the past seven or so years did not get rid of China’s external surplus, as national savings remained exceptionally high. A more normal level of investment would mean—absent other changes in China that reduce its high level of national savings—less demand from China and more spare Chinese savings that would need to be exported to the world. Maybe a new rise in China’s surplus would be offset by a fall in the surplus of Europe, or the Asian NIEs. But, then again, maybe not. * For East Asia, I summed the surpluses of China, Japan and the NIEs (Korea, Taiwan, Hong Kong and Singapore). I added the surpluses of Sweden, Denmark and Switzerland to the euro area’s surplus to provide a fair comparison. Norway was left out because its surplus hinges on the price of oil.

It turns out Germany has fiscal space even by German standards! Germany’s federal government posted a 1.2 percent of GDP fiscal surplus in the first half of 2016. The IMF was forecasting a federal surplus of 0.3 percent (and a general government deficit of 0.1 percent of GDP—see table 2, p. 41); the Germans over-performed.* Germany’s ongoing fiscal surplus contributes to Germany’s massive current account surplus, and the large and growing external surplus of the eurozone (the eurozone’s surplus reached €350 billion in the last four quarters of data, which now includes q2). The external surplus effectively exports Europe’s demand shortfall to the rest of the world, and puts downward pressure on global interest rates. Cue my usual links to papers warning about the risk of exporting secular stagnation. Martin Sandbu of the Financial Times puts it well. "The government’s surplus adds to the larger private sector surplus which means the nation as a whole consumes much less than it produces, sending the excess abroad in return for increasing financial claims on the rest of the world. German policymakers like to say that the country’s enormous trade surplus is a result of economic fundamentals, not policy—but as far as the budget goes, that claim is untenable. Even if much of the external surplus were beyond the ability of policy to influence, that would be a case to use the government budget to counteract it, not reinforce it." The Germans tend to see it differently. Rather than viewing budget surpluses as a beggar-thy-neighbor restraint on demand, they believe their fiscal prudence sets a good example for their neighbors. But its neighbors need German demand for their goods and services far more than they need Germany to set an example of fiscal prudence. It is clear—given the risk of a debt-deflation trap in Germany’s eurozone partners—that successful adjustment in the eurozone can only come if German prices and wages rise faster than prices and wages in the rest of the eurozone. The alternative mechanism of adjustment—falling wages and prices in the rest of the eurozone—won’t work. German fiscal expansion, especially if channeled to public investment that spurs private investment and spills over the rest of the eurozone, thus would help others achieve their fiscal goals. Stronger demand in Germany would raise exports, pulling up output and tax revenues. See this 2014 IMF working paper. If nothing else, Germany’s 2016 surplus allows the IMF to easily recalibrate its 2017 fiscal recommendation for the eurozone. It looks like the German fiscal expansion that the IMF initially projected for 2016 didn’t happen (the IMF projected a half point increase in government spending relative to GDP and a 20 basis points fall in revenue relative to GDP in 2016). Which makes it easy for the IMF to call for an expansion that brings the surplus down to zero in 2017, and in the process helps to offset the negative fiscal impulse likely to come from Spain and others. The IMF is still reluctant to call for external surplus countries to run (modest) budget deficits. But it has been willing to call for countries with external surpluses and budget surpluses to bring their budgets back to balance. * The general government balance captures spending by the regional governments, it provides a broader measure of Germany’s fiscal stance than the federal budget.

The eurozone collectively has a substantial external surplus, and its economy is operating below potential. In the framework set out in the IMF’s external balance assessment, that pretty clearly calls for fiscal expansion: "Surplus countries that have domestic slack need to rely more on fiscal policy easing, which would address both their output gaps and their external gaps... Meanwhile, deficit countries should actively use monetary policy, where available, to close both internal and external gaps." But is the IMF following its own advice (for a currency union that has an external surplus and domestic slack, I am well aware of the fact that the eurozone is not a single country with a single fiscal policy) and actually recommending a fiscal expansion in the eurozone? Best I can tell, no. Not for 2017. The IMF of course is for more fiscal stimulus at the European level. But that is a hope, not a reality. The capacity for a common eurozone fiscal policy conducted through borrowing by the center doesn’t currently exist, and it realistically isn’t going to materialize next year. That means the eurozone’s aggregate fiscal impulse is the sum of the fiscal impulses of each of its main economies. What does the IMF recommend there? In Italy the IMF seems to want about a half a point of structural fiscal consolidation (see paragraph 35 of the staff report). In France, the same (see paragraph 33 of the staff report). In Spain, the last IMF article IV called for a half a point of consolidation as well (see paragraph 33). That though is likely to be ratcheted up, as Spain hasn’t done much consolidation over the past two years and now will need to engage in a major consolidation to get to the Commission’s 3 percent of GDP fiscal target in 2018. Spain, Italy, and France collectively account for a bit more of the eurozone’s GDP than Germany and the Netherlands. So, is the IMF recommending enough fiscal expansion in Germany and the Netherlands to assure a positive fiscal impulse for the eurozone as a whole? No. The IMF is now advocating that Germany avoid returning to a structural surplus, and invest any windfall savings from higher than expected revenues or lower interest rates. But the IMF isn’t advocating Germany do any more on net than it already had done. Germany delivered a significant stimulus is 2016, but it was a one and done stimulus. Germany isn’t projected to generate a positive fiscal impulse in 2017.* The Netherlands needs stimulus on purely domestic grounds given persistent weakness in household demand and an ongoing output gap (see the "Tricky Balance" chart in the IMF’s external balance assessment). And the IMF did recommend a modest fiscal expansion in its last assessment of the Dutch economy. But also it didn’t protest too much when the Dutch government politely declined. See paragraphs 14 and 15 of the 2015 staff report. Bottom line: Germany’s 2017 fiscal impulse is projected to be neutral. The fiscal expansion the IMF recommended in the Netherlands for 2017 is not likely to be adopted and even if adopted it would be too small to offset the fiscal consolidation the IMF is recommending in Spain, Italy, and France. Given the weight of France, Italy and Spain in the eurozone, this implies the IMF is recommending that the eurozone as a whole consolidate next year. And in the IMF’s global framework, that implies the IMF is currently recommending policies that would tend to raise the eurozone’s external surplus. That goes to a larger global problem. The IMF’s framework for looking at external balances says, more or less, that intervention in the foreign exchange market has only a modest impact on external balances.** The policies that matter are healthcare spending, and of course, fiscal policy. The IMF always lives up to its mostly fiscal reputation. The implication, if the IMF wants to be symmetric and worry about global demand as well as global balance of payments adjustment, is that the IMF needs to be as aggressive in recommending fiscal expansion in surplus countries as it is in recommending fiscal consolidation in deficit countries. Judging by its recommendations in Europe, it still has a way to go. In addition to watching the IMF’s aggregate recommendation for the eurozone, I also will be watching the IMF’s 2017 fiscal recommendation for Korea—which has a German-sized current account surplus and, broadly speaking, a German fiscal policy (counting the off-budget surplus in Korea’s social security fund, Korea ran a general government surplus in 2015).*** And its last stimulus package seems to lack what the Japanese would call fresh water. There is of course a second, more straight forward argument for why the IMF might want to encourage Germany to do a bit more public investment in 2017: It offers the most obvious way to help insulate Germany from a slowdown in British demand. The IMF’s initial analysis of Brexit suggested it might knock 20 basis points off eurozone growth in 2017. The hit to Germany, though, was bigger—more like 40 basis points. Logical, given Germany’s greater dependence on exports. Germany’s 2017 nominal wage growth—judging from the contracts agreed this spring—also looks to be slower than in 2016. All in all, it would seem like there is ample reason for the IMF to encourage Germany to offset the impact of the drag expected from Brexit with a looser fiscal policy in 2017 and 2018, even if that means Germany would need to run small structural fiscal deficits for a time. It would support German growth in the face of an expected external shock. It would help ease the pressure on monetary policy when the ECB is at the zero bound. It would make it easier for Italy, Spain, and France to offset the demand drag from fiscal consolidation through exports, and thus facilitate the eurozone’s internal rebalancing. And it would help reduce the eurozone’s contribution to global current account imbalances. Note: edited slightly after publication; I had "internal" when I meant "external" in the last paragraph * Germany did provide a solid (around 1 percent of GDP) fiscal stimulus in 2016 in response to the migrant crisis, as the IMF estimates it moved from a 70 basis points of GDP general government surplus to a 30 basis point of GDP general government deficit. But now that Germany no longer has a surplus, the politics of further stimulus get complicated. The IMF’s staff report emphasized that any further public investment needs to be Within the fiscal rules ("Fiscal resources available within the envelope defined by the fiscal rules, including in case of overperformance, should be used to finance additional public investments...") and the debt brake doesn’t leave much space (see paragraph 49 of the 2016 staff report; the fiscal impulse is from table 2 of the staff report. ** This gets technical. In the IMF’s analytical framework, the intervention variable is interacted with the capital controls variable, reducing its impact. The capital controls variable is never “1.” For China, for example, it was 0.5 last year. So a percentage point of GDP in Chinese intervention could not have more than a roughly 17 basis point impact on the current account (the 0.45 intervention coefficient is multiplied by capital controls, which are now rated at 0.38 on a 0 to 1 scale. For Korea, a percentage point of GDP intervention could not have an impact of more than 6 basis points, given the 0.13 intensity of Korea’s controls. This is well below the impact that the Peterson Institute’s Joe Gagnon has estimated. And the impact is further reduced by the fact that the relevant variable is the gap between a country’s current level of controls and the optimal level of controls. So if the IMF (wisely) believes China isn’t ready yet to liberalize its financial account, the impact of intervention in generating a “policy gap” falls further. Right now, given the size of the capital controls gap for China, a dollar of intervention in China results in only a ten cent change in the current account. It doesn’t matter much now, as emerging markets sold reserves in 2015 and so far in 2016. But the net effect is that in the IMF’s framework, intervention never had much of an aggregate impact even back when there was a lot of intervention. *** The IMF is recommending medium-term fiscal consolidation in Japan, China, and the eurozone. Fairly substantial consolidations too (see table 3 of this report, look at what the IMF calls P* or "optimal" policies and compare that with the current estimated fiscal balance; the full underlying analytics are here). It is recommending a small medium-term fiscal expansion in Sweden and Korea. Both countries ran general government surpluses in 2015, and the IMF is calling them to bring those surpluses to zero or run a small (10 basis points of GDP) general government fiscal deficit. But the resulting swing in the fiscal balance is modest relative to the size of the Swedish and Korean current account surplus. For Germany, the IMF is recommending a fiscal expansion relative to its 2015 surplus; but, as noted above, that stimulus occurred in 2016, and the IMF isn’t currently calling for more stimulus. I should note here that the recommended fiscal stance in the IMF’s external balance assessment is for the medium term; just because the Fund recommends a medium term on-budget consolidation for say China doesn’t mean it recommends an immediate on-budget fiscal consolidation. That said, given China’s extremely high national savings rate and the need for corporate deleveraging, I personally do not see why China could not sustain on-budget fiscal deficits of around 2 percent of GDP in the medium term.

From afar, it seems like the wheels of European policy may be moving towards some kind of near-term fix for either Italy’s banks—or, more likely, for the specific problems of Monte dei Paschi di Siena. The risk here is obvious. The intersection of Italian politics and European rules is pushing for the most narrow of solutions, one that will not recapitalize the broader Italian banking system. At least not quickly. The recapitalization need even under pessimistic assumptions is actually fairly modest, as such things go. Less than Spain spent on the two rounds of recapitalization that were required to solve Spain’s banking crisis. Maybe less than the €30 billion Germany injected into Commerzbank and a few others in 2009, or the massive “bad” bank it set up for Hypo Real Estate (Hypo Real Estate was not retail funded, and even now, it seems like it has some performing subordinated debt—who knew). Probably less, relative to the size of Italy’s economy, than the €22 billion that the Dutch put into ABN-Amro. But Italy’s government clearly doesn’t want to bail-in the heavily retail holders of Italian subordinated debt. Monte alone has about €5 billion in subordinated debt, and over 60 percent of that seems to be held by retail investors. A smaller subordinated debt bail-in late last year was politically controversial. And Europe wants Italy to respect the banking and competition rules, which have been interpreted to require some form of subordinated debt bail-in. There are ways around the ”banking union” Bank Recovery and Resolution Directive (BRRD) bail-in requirement (8 percent of liabilities, a sum that implies a substantial write down of the subordinated debt). Europe’s rules already include an exemption for a precautionary recapitalization to address difficulties identified in a stress test. Getting around the state aid requirements seems harder, though perhaps not impossible if some of the flexibility used in the global financial crisis remains.* The easiest way to protect the retail investors in the subordinated debt and to avoid violating any European rules, obviously, is for the banks to continue to carry the bad loans on their books at an inflated mark. There is a reason why nothing much has been done. The current stress tests are rather narrow. They only will cover a subset of the Italian banks now supervised by the ECB. On their own, they will not force a broader solution. The FT has reported that the Italians are working on an “Italian” solution that would both recapitalize Monte Dei Paschi and avoid triggering the state aid rules. The Atlas fund would be reinforced (in part with funds from the state owned Cassa Depositi e Prestiti) and used to purchase a slug of Monte’s bad loans at a higher price than a private equity fund would, and a convoy of Italian financial firms would participate in an equity infusion. The problem with any narrow fix is that it will not really change Italy’s basic dynamics. The combination of banks that are too weak to lend and pressure to do more fiscal consolidation doesn’t provide an obvious path out of Italy’s prolonged slump. Monte alone accounts for about one seventh of Italy’s bad loans (€50 of €360b), so solving Monte’s problems isn’t irrelevant. The big two (Intesa and Unicredit) hold another €140b or so. Unicredit is expected to face pressure to build up provisions or capital after the stress tests as well. But that leaves another €170b or so outside of the top three institutions. Emma Smith of the CFR’s Greenberg Center for Geoeconomic Studies prepared the following table, based on publicly available information and the data in the Bank of Italy’s financial stability report. For this analysis, Emma and I combined the provisioning on bad loans with the provisioning on other impaired exposures. The good news is that the “tail” of smaller institutions in aggregate looks to be in somewhat better shape than Monte. The bad news is that the smaller institutions are not in great shape. A Texas ratio (common equity and provisions v bad loans) of around 1 for the smaller institutions isn’t good. Banco Popolare and Banca Popolare di Milano—who are now seeking to merge—have a relatively low level of provisions relative to their bad loans. Maybe their bad loans are of better quality. Who knows. Their relatively low level of provisioning isn’t new. It will have to be addressed as some point. The best solution here would be fairly clear. A public recapitalization that covers the full banking system and lets the banks mark down their impaired exposure to a reasonable level and move forward. Italy didn’t do a major recapitalization immediately after the crisis, as its crisis has been more of a slow burn. It is now paying a price. Spain’s banking system in 2010 actually had some similarities to Italy’s structurally, even though Spain’s risky exposure was more concentrated in real estate. The two bigger, more international banks that were in relatively better shape. Some mid-sized troubled institutions, created through perhaps unwise mergers (Bankia most obviously). And lots of small institutions. Not as many as Italy. But lots. In the first round of Spain’s recapitalization, which consolidated a number of the cajas, I do not think there was any subordinated debt bail-in. In fact, it seems like some subordinated debt was paid down during the initial recapitalization phase, and there was certainly a rotation away from institutional investors and toward retail investors as some of the subordinated debt issued before the crisis was replaced by new retail placements (see this study). During the second round, in 2012 and 2013, there was a bail-in. But the bail-in requirement was interpreted fairly flexibly if my memory holds. Bankia’s capital need was such that I think you could easily have argued both the preferred equity and the subordinated debt should have been more or less completely wiped out to limit the amount of needed state aid. Counting both rounds of recapitalization, it received close to €20 billion in state aid. Subordinated debt (at least the subordinated debt with a defined maturity) only took a nominal 13 percent haircut**—though investors were given the option of not swapping into Bankia equity and instead getting a bond or a time deposit (for some smaller banks, the government facilitated a clean exit into cash). There are models here if Europe wants to use them. Most pre-date the BRRD, but the stress test already allows Italy to skirt the 8 percent bail-in requirement. And, well, my personal view is that the transition to a banking union based on uniform resolution and recapitalization rules, consolidation of supervision for large banks at the ECB, and no real fiscal risk sharing (there is no common deposit insurance, and the resolution fund is in practice a network of national funds) was a bit premature. A banking union with limited risk sharing will only work if the rules initially are applied with a lot of flexibility. Especially as it is now clear that the initial round of stress tests didn’t clear away all legacy loan exposures, or put to rest concerns that many of Europe’s banks are under-capitalized. Right now Italy effectively needs to solve for Italian banks who have raised funds from Italian depositors and investors, not for European banks who happen to have their headquarters in Italy. Portugal will be more complicated. [*] For the recapitalization of a solvent institution that is not being wound down; for Monte this means that the “stressed” losses cannot exceed its capital of around €8 billion. Stricter bail-in rules apply for “resolution.” [**] The preferred equity took a larger haircut, but it wasn’t wiped out. In the capital stack, senior bonds rank higher than subordinated debt and subordinated debt ranks higher than preferred equity.

Rules are rules and all. But the application of poorly conceived rules is still a problem. Especially in the face of a negative external shock. The eurozone’s fiscal policy is, more or less, the fiscal policy adopted by its constituent member states. Wolfgang Schauble (do follow the link) should be happy: Europe’s fiscal policy is almost entirely inter-governmental. The eurozone’s big five—Germany, France, Italy, Spain, and the Netherlands—account for over 80 percent of the eurozone GDP. Summing up their national fiscal impulses is a decent approximation of the eurozone’s aggregate fiscal policy. And, building on the point I outlined two weeks ago (and that my colleague Rob Kahn echoed on his Macro and the Markets blog), 2017 could prove to be a real problem. Bank lending now looks poised to contract, and eurozone banks face (yet again) doubts about their capital. And the sum of national fiscal policies—best I can tell—is pointing to a fiscal consolidation. In the face of the Brexit shock, standard (MIT?) macroeconomics says that a region that runs a current account surplus, that has a high unemployment rate, that has no inflation to speak of, that cannot easily respond to a short-fall in growth by lowering policy interest rates (policy rates are, umm, already negative, and negative rates are already, cough, adding to problems in some banks), and that can borrow for ten years at a nominal interest rate of less than one should run a modestly expansionary fiscal policy. The eurozone as a whole clearly has fiscal space. The eurozone’s aggregate fiscal deficit is lower than that of the United States, Japan, the United Kingdom, and China. Adjusted for the cycle, the IMF puts the eurozone’s overall fiscal deficit at about 1 percent of GDP (without adjusting for the cycle, the eurozone’s overall deficit is around 2 percent of GDP). Even without any cyclical adjustments, the eurozone now runs a modest primary surplus, and simply refinancing maturing debt at current interest rates should lead to a lower headline deficit. But the eurozone isn’t a unified fiscal actor. Right now the countries that could run a bigger fiscal deficit without violating the eurozone’s rules have said they won’t, and the countries that are already running deficits that violate the rules are facing new pressure to comply with the rules. The aggregate fiscal stance of the eurozone thus is likely to be contractionary. Germany of course is the best case of a country that the market wants to finance. Germany actually did do a fiscal expansion in 2016. It had a fiscal surplus of almost a percent of GDP in 2015, and in 2016 it is projected to be in balance. (See the IMF Article IV report) But on current plans Germany won’t do more in 2017 as more would mean a deficit. The fiscal impulse from here out is thus likely to be flat, barring a major policy shift. The Dutch have, by any reasonable estimate, enormous fiscal space (massive current account surplus, low gross debt, tons of pension assets, and, the market is willing pay the Dutch government to borrow, at least for maturities shorter than ten years). But the Dutch too do not seem to want to use their fiscal space. The European Commission lauded the Netherlands fiscal policy precisely because it was committed to bring a 2 percent of GDP fiscal deficit down to between 1 and 1.5 percent of GDP in 2017. With a structural deficit estimated to be a bit over 1.5 percent of GDP in 2015, the commission believes further consolidation is required to get the Dutch structural deficit down to the target of half a point of GDP. No matter that there has been a persistent problem with demand in the Netherlands. France has somewhat higher debt levels than Germany or the Netherlands. But a country that currently can borrow for ten years at twenty basis points, a rate well below the interest rate the market charges the United States, also doesn’t need to consolidate today. Consolidation now—if you believe Fatás and Summers—might well raise debt to GDP levels. But that doesn’t seem to be the commission’s view. The commission’s 2015 report emphasized that France had failed to do enough structural consolidation in 2015, and argued it wasn’t planning to do enough in 2016 either. It is hard to see the commission changing its tune for 2017.** Italy is gearing up for a bit of bank recapitalization. Without a bit of flexibility, the accounting for the recapitalization will push Italy’s headline deficit above 3 percent. The odds are Italy will be called to tighten, at least a bit. Especially because Italy is going to be more or less permanently in violation of the rule that says that European countries with high debts need to bring down their debt-to-GDP ratios with austere budgets. And then there is Spain. Together with Portugal, it runs the risk of being sanctioned by the commission for an excessive deficit. Five percent of GDP isn’t all that close to three percent of GDP. The Financial Times reported back in March: "Spain has veered sharply off course in its long-running effort to reduce the budget deficit, unveiling a 5.2 per cent shortfall in 2015 that is likely to raise alarm inside the European Commission and impose significant political constraints on the next Spanish government... The shortfall is almost a full percentage point above the deficit target set by Brussels ... Crucially, the gap also makes it all but impossible for Madrid to comply with its target of reducing the shortfall to below 3 per cent of gross domestic product this year." Spain is now set to be sanctioned by the commission, which made clear in its 2015 report that Spain has been running far too loose a fiscal policy (never mind that demand is still down 10 percent relative to pre-crisis levels, that unemployment is shockingly high, and that the period of too-loose-for the-commission fiscal policy was a period of recovery) over the last two years. The commission recently indicated that Spain would have needed to do about 2 percent of GDP more consolidation to have hit European targets over the last several years. "The cumulative structural fiscal effort over the 2013-2015 period is estimated at 0.6% of GDP, significantly below the 2.7% of GDP recommended by the Council." It isn’t much of a leap to think that Spain will be asked to do to a bit of structural consolidation in 2017, and the fiscal impulse in Spain will turn significantly negative.*** So if Germany and the Netherlands won’t run a bigger deficit, and if France, Italy, and Spain are all supposed to consolidate, how exactly can the eurozone, as currently constituted, generate a positive fiscal impulse? It certainly won’t come from Portugal. While there is room to debate the correct fiscal stance for each individual country, it also seems clear to me that the sum of the commission’s national fiscal recommendations would imply a reasonably contractionary fiscal policy for the eurozone as a whole. And if applying the national rules produces a policy that it is too tight for the eurozone as a whole, that to me implies that the rules as currently constructed are part of the problem. Tis a shame really. In 2016 the eurozone was actually experiencing somewhat decent growth pre-Brexit. Eurozone growth exceeded U.S. growth in q4 2015 and q1 2015. And if you have a Keynesian bent, you can explain the eurozone’s 2016 growth pretty easily. Events conspired to make the eurozone’s fiscal stance for 2016 fairly expansionary. The Germans stopped running a 1 percent of GDP fiscal surplus. The Dutch, it seems, quietly allowed their structural deficit to widen a bit. And Spain got a reprieve going into its election cycle. The IMF recently estimated the eurozone structural deficit widened by about 40 basis points of GDP in 2016, generating a positive fiscal impulse in Europe for the first time in a long time. Many smart observers of European policy tend to think the eurozone’s 2017 fiscal stance won’t be as bad as I fear. They argue that the commission’s position is just an opening bid designed to raise their credibility in Germany, and pragmatism will win out in the end. I am not so sure. On Europe’s current course, there is a real risk that renewed bank deleveraging will be combined with renewed fiscal consolidation. * One percent comes from looking at the GDP weighted average 10 year rate. ** The IMF, unfortunately, echoed the commission in its Article IV report on France: "Structural adjustment over 2015–18 is projected to average 0.1 percent of GDP, well below the EC’s recommendation. Without further efforts, France will not reach the structural balance objective within the five-year projection horizon." See p. 11. *** More on Spain from the commission; the cumulative shortfall in fiscal effort now looks to be about 3 percent of GDP: “On a cumulative basis over 2013-2016, the shortfall with respect to the effort that was recommended by the Council amounts to 3.1 pps, when measured against the uncorrected change in the structural balance, and to 4.4 pps. when referring to the corrected indicator."

Three things to think about today.  If you haven’t already done so, subscribe now to my colleague Brad Setser’s blog, which provides excellent commentary on global macro issues. His most recent piece makes a compelling case for European fiscal action against the backdrop of a meaningful UK and European growth shock, a point that I very much agree with (listen also to my conversation with Jim Lindsay and Sebastian Mallaby here). I remain puzzled that this industrial country growth shock has not had a broader effect on emerging markets. Reports are that portfolio outflows from EM were minor on Friday, with some recovery this week. One view is that as long as China’s economy remains on track, commodity prices hold up, and the Fed is on hold, emerging markets should weather the Brexit shock. Conversely, the IMF has worried that declining trend growth in the emerging world reflects a rising vulnerability to globalization. The humanitarian situation in Venezuela has become critical. I have focused in past blogs on the severe economic consequences of the crisis, and the need for a comprehensive, IMF-backed reform effort, supported by substantial financing and debt restructuring. China’s recent agreement to push back debt payments due recognizes the inevitable but is unlikely to provide additional free cash flow to the government or the state energy company PDVSA. For investors, default now looks to be coming soon.