Sunday, 24 August 2014

European hot spots

Recently Germany has been in the spot light for underperforming industry & financial figures but it is not the only one. Italy is now going through what has been officially termed a triple dip recession.

This is an interesting theoretical nicety, but in fact what is happening in Italy at the moment goes a lot further than problems faced by a recession dating committee. The real issue that arises in the context of the Euro Area at the moment is a far more specific one. Will the ECB [European Central Bank] do QE [quantative easing]?

Everyone knows that Italy is back in recession following the 0.2% GDP contraction in the second quarter. Not only did this result suggest that Italy was now in a triple dip recession [or a twenty year decline], it also meant that GDP [gross domestic product] was back at the same level it had in 2000, when the country entered the Euro currency union, this is a surprise. The problem is that Italy has an appallingly low trend GDP growth rate [possibly negative at this point] and nothing which has happened since the financial crisis ended suggests it is going to improve radically anytime soon, in fact there are good reasons to think that  growth could  even deteriorate further.

The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP [or GDP at current rather than constant prices]. If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even continue to contract [as has happened in Japan]. The result is bound to be that the gross government debt to GDP ratio rises above the 135% it hit in March.

One of the arguments frequently advanced about how this dynamic could be turned around would be for Italy to run a “large” primary budget surplus. Now the emphasis here is on large since the country has in fact run a primary surplus [income / expenditure before paying debt interest] since the early 1990s, but that has not stopped the weight of the debt climbing and climbing.

Italy’s debt now looks certain to climb towards 140% of GDP and beyond [maybe hitting that level as early as Q1 2015], meaning someone somewhere in the official sector should be able to recognize that it is not on a sustainable path. The so called AQRs [bank asset quality reviews] are probably not going to generate too many surprises, but what about doing some realistic DSA’s [debt sustainability analyses]?

So EU leaders and the ECB now face a dilemma. Trying to make Italy comply with its EU deficit and debt obligations may well mean that the deficit comes down but in all probability the debt level will go up given the weak nominal GDP effect.

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