Italy: The Dragon and the Cricket

The difficulty in making sense of the results of the Italian election has produced the common imagery of a clown to capture the comic Grillo, who appears to be the most unlikely politician since Lech Walesa, the unemployed electrician that led Solidarity in Poland, helping to bring the fatal crisis upon the Soviet Union, and the general disdain for Berlusconi, whose political career appears driven as much by the need to avoid prison as anything else. While understandable, it confuses name calling for analysis.

Moreover, it does not do justice to the two key forces in Italy, the dragon, Draghi, the president of the ECB, and Grillo, which means "cricket" in Italian, the head of what has emerged as the largest single political party, his 5-Star Movement (M5S).   The near-term political future appears to be in Grillo's hands and there will be much speculation ahead of the end of the week when the Italian parliament will formally gather, for the first time since the election, to select a president of each chamber.

When Fitch cut Italy's credit rating to BBB+ from A before the weekend, it cited the inconclusive election that is not conducive to structural reforms.  It also weakens Italy's ability to respond to shocks, such deeper domestic contraction or a broader crisis within the euro area.  Pshaw.  It was simply a timely excuse to align its rating.  It was the outlier.  It matches what S&P had done a year ago and is still above Moody's Baa2 (equivalent to BBB).  Fitch's move contains no new information.   Earlier in the week, the DBRS cut its rating of Italy to A (low).   

One of the important implications of additional downgrades--and as it is on negative watch by all these agencies, it is a realistic possibility-- is that it will increase the haircut applied to Italian bonds as collateral with the ECB.  Italian banks appear to have a sufficient cash cushion to absorb the hit initially, but the degrees of freedom can be exhausted quickly.  In turn, this suggests why Italian banks do not appear to have returned much of their LTRO borrowings and why they won't until the situation is clarified, which could take the better part of the remainder of the year.  

Cricket, not clown may be a more apropos image of the 5-Star Movement.  There are several characteristics of a cricket that are revealing.  Crickets are easily and often confused with something they are not (grasshoppers).  The males of both do make a chirping sound, but the cricket is more noise than action.  Grasshoppers are pests and plague farmers.  Crickets are considerably less harmful; perhaps because they live for a few weeks, while a grasshopper can live for a year.   What also may prove prescient, crickets are known to eat their own dead.  Aside from America's experience, revolutions are often known to eat their children.  

Grillo heads up a movement, and is probably as surprised as anyone with the electoral outcome.  Just like nature abhors a vacuum so do politics, and as a movement the M5S moved into the vacuum created by four separate, even if related, developments.  First, on the European level, there appears to be a lack of leadership from those, like French President Hollande, to articulate a practical vision of EMU that is not dominated by the interests of the creditors.  Second, within Italy, the center-left coalition (PD) failed to offer an alternative to Monti's austerity program.  Third, no group speaks for the high unemployment among college educated young people.  Fourth, there was no local expression of the Occupy Movement, the Pirate Party in Germany, or a non-marxist ecological movement.  

The key issue is whether Grillo can form a party out of the movement.  Despite early successes, the Pirate Party in Germany appears to be imploding as members save their most vile recriminations for each other, rather than their opponents.   The Occupy Movement has not crystallized into a party. The Tea Party has been among the most successful, perhaps because it is essentially a faction within a party, and its story still seems to be unfolding, though by some reckoning, it has passed its peak in terms of influencing the agenda.  

Berlusconi seemed to campaign against Germany and Merkel, whom he implies forced him out of the office back in late 2011.  Grillo, on the other hand, seemed to campaign more against Europe.  While the two may seem similar, Grillo's line of attack is broader and more profound.  Grillo's rhetoric gave expression to a powerful antagonism against the elite.  Although Berlusconi is not liked by the Italian elites, he is one of them.  They are the target of Grillinis' scorn. 

The M5S program blurs the political spectrum.  Although Grillo is 64, he successfully articulates the angst of the well-educated, but under-employed and unemployed, young people.  One study of the Gillinis found 46% come from the left and 39% from the right.  They are inheriting an economy that posts meager growth even in the best of times, a high public sector debt burden, and a political culture of corruption, even after the Clean Hands drive and the expunging of a previous political elite.

We can recognize Abenomics as monetary and fiscal stimulus on steroids, but Grillonomics is a kaleidoscope of  ideas that is more like a movement's slogans than planks of a party platform.  Indeed, as the M5S becomes more programmatic and specific, the less cohesive it will become.  Much to their surprise, the M5S may also find that politics make strange bedfellows.  

In the name of anti-bureaucracy, and to reduce the arena of public corruption, Grillo has called for extreme deregulation and privatization and large-scale reduction in the number of civil servants.  He wants to end the state-monopoly on the railways.  This gives him much in common with the right.  The xenophobic and anti-immigration strain that is evident also appeals to some on the right.  

In other ways, Grillo is more to the left than the PD.  He wants the state to give 1000 euros a month to every one.  Grillo has advocated tying managers' salaries to average worker pay and break up (and/or nationalize) the banks and industrial monopolies.  The M5S speaks more to those on the make than those who have been made.  

Grillo's proposals, including tying the universities more to business and raising health care charges, suggest a desire to re-write the social contract. The danger is that the changes he seeks may weaken the very constituency he represents.    For example, renegotiating Italy's debt sounds like a swell idea, lighten the burden for the generation coming of age or came of age recently.  Yet 60% of Italy's debt is owned domestically.  A debt restructuring would hurt Italian pensioners, hit household savings, and trigger a financial crisis, not just in Italy, but all of Europe.  The economic consequences would be severe.  

It is unclear how the M5S and its constituents would benefit from leaving the monetary union, which Grillo has threatened.  The result would make the current recession look desirable in comparison.  Any competitive gain by a new and devalued lira would be offset with what likely would be a sharp increase in interest rates and a financial crisis.  Moreover, and very importantly, outside the EMU, the need for structural reforms becomes even more urgent.

Indeed, the latest ISOP poll found 74% of Italians favor retaining the euro, with only 16% wanting to go back to the lira.  More than two-thirds of Italians are not in favor of an EMU referendum, leaving slightly less than a third wanting one.

The World Bank ranks Italy near the middle of the world in terms of its Doing Business evaluations, which is rather poor for a high income country.  Of note, Italy, ranks 160th in enforcing contracts, 131 in paying taxes, 107 in getting electricity and 103 in dealing with construction permits.

At the recent ECB meeting, Draghi showed no urgency to take additional measures to help ease the economic contraction or blunt the tightening of financial conditions, seen in the contraction in loans to the private sector and weak money supply growth.  While willing to counter threats against the EMU itself, the ECB quite tolerant of market forces pressuring governments to do the "right thing".

The ECB's Outright Market Transaction scheme is not relevant in the current circumstances for Italy.  Recall that the pre-conditions require a programmatic agreement with the EU.  Italy is far from that.  By some reckoning, Spain is still closer, though Spanish bonds have benefited from the political uncertainty in Italy.

Italian bonds and stocks have recouped much of the initial losses seen in the immediate aftermath of the election.  Italy has among the smallest budget deficits in Europe and is the only one with a primary surplus.   To service its debt, however, Italy does have to sell about 30 bln euros of bills and bonds a month.  It is trying to extend maturities, where the average is already at the upper end of the euro area ( a little more than 7-years).

There have been reports that the ECB was contemplating leaving the Troika (EU, IMF and ECB), but there is not a formal group as such and the reports were denied.  Nevertheless, the kernel of truth is that the ECB is increasingly isolated within the group that has acted as the financial judge and jury of the euro area sovereigns.

The EU is considering giving several countries extra time to reach their fiscal targets.  The IMF has, a bit belatedly, recognized that the fiscal multiplier (the impact of a cut in government spending on the overall economy) is greater than it previously assumed.  It is more sympathetic to an official sector participation in debt restructuring, such as in Greece, although it insists that it is excluded.  IMF's Lagarde has also called on the ECB to cut rates and reiterated her call over in recent days.

Lagarde recognizes that lower inflation and wage restraint in the periphery requires somewhat higher inflation and wages in countries like Germany, which the ECB is reluctant to see.  Yet, almost on cue, the 765k state government workers (represented by Verdi) in Germany reached a 2-year agreement on March 9, for a wage increase, which at 5.6%, is above the inflation rate.  It includes a 2.65% this year, retroactive to Jan 1 and a 2.95% hike next Jan.  The agreement effects 15 German states.  Only Hesse which is not part of the collective agreement, is not formally taking part.

German inflation is stood at 1.5% in Feb, the lowest since December 2010.  Recall last March the federal and municipal workers received a 6.3% wage increase over two years.  Even if the cynics are right and electoral considerations (election in Sept) are playing a role, the fact is that the increase in German labor costs may help the re-balancing of euro area growth more than the harsh austerity alone in the periphery.

A dragon he may be, but Draghi is does not breathe fire any more.  The high bar to triggering OMT means that it cannot be implemented quickly, or as part of a crisis response program.  With the zero deposit rate the real anchor for short-term rates, even a 25 bp cut in the 75 bp refi rate will only have minimal impact.  Easing collateral rules remains possible, but there is a reluctance, especially by the creditor nations, to risk weakening the ECB's balance sheet any more.

Meanwhile, the ball is in the crickets' court.  Grillo and the M5S movement are hardly a political party, though it is clearly a force to be reckoned with.  Some of its program will likely be assimilated by the right and left.  More than a little late, Monti himself softened his austerity push in the last days of the campaign.  The election may prove cathartic, an expression of frustration and dissatisfaction with the political elite in Italy, but the Italian body politic is not about to decapitate itself.

(see our previous analysis of Monti here)