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All roads lead to Rome but few lead to Italian debt sustainability

All roads lead to Rome but few lead to Italian debt sustainability

29-10-2018 | 5-Year outlook

It was a warning made two and a half centuries ago – but it has stood the test of time. Adam Smith’s famous remarks about the dangers of the ‘juggling trick’ of printing money to underpin huge government debt seem more appropriate than ever, say Chief Economist Léon Cornelissen and strategist Peter van der Welle.

Speed read

  • Japan presents a masterclass in manipulating bond markets
  • Populist Italian government could fall foul of EU or even exit
  • Debt situation in west unlikely to improve in next five years
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It was the 18th century economist Adam Smith who first warned of ‘pretended payment’ – paying off debts by printing money, creating a “juggling trick” that would probably now also include quantitative easing. And as western governments led by Italy and Japan build up eye-watering levels of national debt, not much has changed since he wrote his famous words in 1776.

Theoretically, governments have four options to cut debt: through GDP growth; by lowering deficits; by raising inflation to devalue the debt; or by going bust. Needless to say, the preferred route is to grow out of the debt load, though growth alone will not solve the problem if government deficits rise at a higher rate.

Inflation certainly works, though a study of six industrialized nations over 1960-2005 concluded that debt was primarily reduced through reducing the fiscal deficit; inflation and GDP growth played a minimal role. And nobody went bust.

Keynes comes back into fashion

The economist John Maynard Keynes argued that a rise in government spending should stimulate growth. Keynesian theory eventually fell out of favor following two large oil crises that brought the stagflation of the 1970s before coming back into fashion during the Great Financial Crisis.

Japan has tried the Keynesian recipe through an endless list of fiscal stimulus programs, focused on building critical infrastructure such as bridges and tunnels. The Bank of Japan was also the first central bank to undertake quantitative easing, pushing interest rates into negative territory.

It recently introduced an even more aggressive tool, which was first used by the US during World War II: yield curve control. Here, the Bank of Japan capped the 10-year interest rate at 0% and can theoretically blow up its balance sheet to infinity, since ownership of government debt is almost completely domestic. In our opinion, this is a clear and extremely powerful and credible example of Adam Smith’s juggling trick.

All roads lead to Rome…

The debt situation in the West is unlikely to improve in the next five years. The US is engaging in a large, unusual pro-cyclical policy experiment which in 2019 will result in a government deficit exceeding 4.5% of GDP. The federal debt will continue to rise and, with an economy already at or near full employment, supply side constraints will likely push up inflation, prompting the Fed to raise rates to keep it in check.

Public debt to GDP ratios of countries in 2011 and 2017; Greece comfortably leads the pack.
Source: Eurostat.

Conversely, the Eurozone is nowhere near full employment, and medium-term inflationary risks are low. The largest risk is the massive public debt in Italy, which currently stands at around 133% of GDP, around two-thirds of which is held domestically. The country has a long history of running primary surpluses, so it has tried to solve its debt problem via the traditional channel – alongside the European Central Bank’s QE program (the juggling act).

The new populist Italian government is, however, an unknown quantity. Would it deliberately enter a power struggle with other Eurozone countries by unilaterally presenting an expansionary budget for 2019 later this year, flunking EU budget rules? We expect the end result to be deflationary rather than inflationary.

Beware the Italexit

Meanwhile, an ‘Italexit’ may well be on the cards. This would lead to debt restructuring in Italy and the imposition of capital controls. As Italy is the third-largest economy in the Eurozone, an Italexit would mean a significant negative supply shock – to both the Italian and Eurozone economies. The effects of this would be highly deflationary, or in any case disinflationary, rather than inflationary.

If, however, the Italian government does comply with EU rules, expectations are that the exceptional monetary stimulus in the Eurozone will be gradually withdrawn. With Italy toeing the line, the ECB could – given the country’s theoretically unlimited balance-sheet size – always cap Italian bond yields, in the same vein as the Bank of Japan’s yield-curve control.

In all, fiscal policy is a key variable to watch in the next few years. The 10-year Italian bond yield has risen 100 basis points since the populist election victory. And recent developments in the Italian bond market underline the lingering risk of a vicious cycle, where higher interest payments create a higher deficit, leading to higher government borrowing, driving interest rates up again.

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Japan keeps on borrowing

Japan currently lacks a convincing program to curb the growth of its massive public debt, standing at a world record 239% of GDP in 2016. A sales tax hike from 8% to 10% planned for October 2019 will go ahead as planned, but fears persist that it could spark a negative growth shock. The debt-to-GDP ratio is therefore expected to rise to 250% GDP in 2030 and could increase further on the back of disappointments concerning public health expenditures.

Given the home bias of domestic investors with relatively high saving rates and the grip the Bank of Japan has on the domestic debt market, debt financing still isn’t considered to be a problem for the foreseeable future. It is also important to keep in mind that the Japanese government has enormous financial assets of around 120% of GDP. Inflationary expectations for Japan will, however, remain subdued for years to come. And Adam Smith’s juggling trick will continue to be used for a while yet.

Expected Returns 2019-2023
Expected Returns 2019-2023
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