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March 06, 2018

Will Italy exit the eurozone? Of course not. But it's the wrong question.

We couldn't suppress a smile this morning when we read in La Repubblica that the Italian election result caused serious concern in the European Commission. Europe's establishment would clearly have preferred a victory by the centre-right or centre-left - the devil it knows. The hope is now that Italian radicals will turn out to be like Alexis Tsipras, who also started out wild and has since been potty-trained. We think such comparisons are wrong for a number of reasons. Greece is a small country with zero blackmail potential. And Greece was in a bailout programme, and thus subject to external controls. Italy is none of the above. It is a net contributor to the EU budget. And it is the third largest economy in the eurozone.

The real danger of a populist government in Italy, run by parties that have at one time or another prioritised euro exit, is not that they will actually go through with it. The danger is that their policies would produce such an outcome by stealth.   

The issue is what will happen if a crisis hits Will it be their priority to stabilise the banking system? Will they adhere to EU rules on bank resolution? Will they adhere to fiscal targets? Our reading of the economic debate in Italy is that there is growing support among radical economists - those supporting Five Star or the Lega - in favour of parallel currency regimes of the kind Tsipras rejected for Greece. This would take the form of bearer bonds, issued by the government, which people can use to settle taxes. The instruments would thus be immediately accepted in lieu of cash.

Another scenario is a return of the sovereign debt crisis, which would occur if financial markets change their view on the sustainability of Italian debt. It will not be so easy anymore for the forces of the Italian and European establishment to get rid of a recalcitrant government, in the way they got rid of Silvio Berlusconi in 2011. That was only possible because of a largely centrist majority in the Italian parliament that was able to bring in a technical government under Mario Monti. We are in the exact opposite situation now. The radicals are in a majority. Five Star and Lega alone have a large majority between them, and that's even witouth the hard left of Liberi e Uguali and the hard right of the Brothers of Italy, an outgrowth of the former fascist party. The forces of liberal democracy, which ultimately underpins the eurozone's fragile governance institutions, are no longer in a position to call the shots. The next finance minister is very likely to be a member of a party that at one time or another advocated Italy's withdrawal from the eurozone.

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March 06, 2018

Slovakia's political crisis

The murder of investigative journalist Ján Kuciak has triggered a serious political crisis in Slovakia. The situation has escalated to Robert Fico insinuating that president Andrej Kiska is part of a foreign campaign orchestrated by George Soros to destabilise the government. The evidence? That Kiska met with Soros in New York last September, and that there have been large public gatherings last week to protest corruption, culminating in street vigils after Kuciak's funeral over the the week-end. Kuciak's last incomplete investigation, published after his death, has revealed ties between Slovak government officials and the Italian 'ndrangheta.

Back in the real world, one of Robert Fico's junior coalition partners, the Hungarian minority party Most-Hid (Bridge), had already asked for the resignation of interior minister and deputy PM Robert Kalinák, and also that of the chief of police. After Kalinák refused to step down, Most-Hid gave until next Monday when they say they will reconsider their role in the government. In the meantime the other coalition partner, the far-right Slovak national party SNS, also asked for Kalinák's resignation. On Sunday President Andrej Kiska said he was not satisfied with the content of a meeting he had with Fico to discuss the situation, and that the crisis of public trust in the government could only be resolved by a deep government reshuffle or new elections. Fico's immediate reaction was to say that Kiska was overstepping his functions, as the president does not have the power to force new elections. But yesterday he doubled down by playing the Soros card. 

The one resignation that did take place was that of culture minister, Marek Mad'arik, who was embarrassed that a journalist was murdered during his tenure. But the minister responsible for people not being murdered is the interior minister, not the culture minister. Mad'arik, who is also a member of Fico's party Smer, is quoted as saying that the resignation of Kalinák might have calmed things down last week, but that the situation now requires a reshuffle. 

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March 06, 2018

Are we heading for a trade war?

Will Donald Trump plunge the world into a trade war? He said he doesn't think there will be a trade war, but we don't think this is a conciliatory statement but one of confidence that his trading partners will roll over and not resist his tariffs. Meanwhile, his administration is hard at work undoing not just the free trade agreements of the last 30 years, but maybe the entire system the US built since WWII. It is worth recalling the recent statement by Wilbur Ross, US trade secretary:

"We have unilaterally given away all kinds of concessions since the end of World War II. In the beginning that was probably good policy … concessions that were perfectly reasonable to make to Germany in 1945 or China in 1945 don’t make sense any more ... Those are very strong, mature economies and there’s a lot of history to be undone."

Did he mean Japan when he said China? Does he really mean to undo history? Do we need to worry? The business wing of the Republican party is beginning to worry as illustrated by House speaker Paul Ryan speaking up against tariffs. The WTO certainly is worried, warning against the first trade war since the 1930s when countries slapped tariffs on each other in a futile attempt to protect themselves from the great depression.

How bad can it get? In his NYT column last Saturday Paul Krugman took a stab at estimating the first-order macroeconomic effects of tariffs, which he says are negative for the US even before considering retaliation by foreign trade partners. Krugman's argument is simple: the US trade deficit of 3% of GDP is about 20% of total imports, which in turn are 15% of GDP. A generalised 20% tariff could shift that 3% from foreign to domestic demand. But the problem is that the US economy is close to full employment, so not all of this extra domestic demand will go to increase output. There will also be domestic inflation to which the Fed will respond by raising rates. It risks tipping the US into a recession. Higher rates would also add upwards pressure to the value of the US dollar, negatively impacting US exports as well.

If Trump imposes steel and aluminium tariffs, and responds to retaliatory tariffs from the EU and now China with another round of tariffs on other products, we may be looking at a generalised tariff of the kind Krugman is considering in his toy model. That would probably be the end of the eurozone's current account surplus, which has been about 2% of GDP for about five years. Given the size of the European economy, such a large surplus can only be sustained if the rest of the world tolerates it. Trump's trade war would be the end of that tolerance.

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