The Harmful Quarrel

As you have doubtlessly heard, Italy has been involved in a quarrel with Brussels since the submission of the Italian budget-law draft by the new populist government, which fixed the deficit spending at 2.4% of GDP, despite the European foreseen limit of 0.8%. Severe consequences have soon come into play. The European Commission President Jean-Claude Juncker reacted with self-defeating affirmations, generating even worse responses from investors both in stock and government bond markets. Finally, the European commission complained formally about the Italian Budget-Law draft in an unprecedented move against a confederated country, starting a three-week countdown to produce a new downsized proposal on pain of strong sanctions[1]. In this European “chicken game”[2], the Italian populist establishment seems to insist on driving straight, as EU threats are perceived as non credible. In any case, history teaches us that, when the “chicken game” goes international, the really troubling and decisive role is played by the audience through its verdict (disinvestments and a rating decrease) on the markets, and the damages of such verdict are likely to hit inside and beyond the Italian borders. Looking at the data: should other members of the Eurozone be scared about what is currently going on in Italy? Of course, considering Italy as one of the driving forces of the European economy, evidence should suggest caution when dealing with this kind of situation. Simply put, the contagionwill probably occur if the subjects are already ill: what we are trying to suggest is that, for instance, the solidity of Germany will not be undermined by what is happening in Italy, whereas those that should be particularly alert are Portugal, Spain and Greece. Should we conclude that these are the only countries on which the “Italy disease” will have an effect? Of course not: no one is able to predict what would happen if the worst case scenario actually materializes. Particularly, the key is to analyze the repercussions of some symptoms of the disease - that have shown up during the last 4 months - on the PIGS, trying to find some evidence on whether there is indeed an amplified connection between these countries. In other words, we are wondering: as the default risk in Italy grows, will the effects be more evident in Portugal, Spain and Greece due to a domino effect? Yes, it turns out that the Italian “populist shock” has reverberated more clearly in such countries. Let us go through this evidence, by analysing four critical steps that have been cause of concern for Italy:

  1. 11/05/2018-27/05/2018: approaches for the formation of the government until Mr. Paolo Savona, described by the media as an “Euro-skeptic”, gets indicated as the minister of the economy.

  2. 04/06/2018-08/06/2018: Italian populist government is finally formed.

  3. 26/09/2018-02/10/2018: the Italian Government presents the draft budget.

  4. 03/10/2018-19/10/2018: tensions regarding the European Commission’s response.

Now let us check the magnitude of the impact of these events on the PIGS. The table below shows the absolute variation of the spread of the PIGS’ government 10 years bond yields against German bond yields.

As you can see, there is a clear positive correlation across PIGS in line with our underlying guess, confirming the idea that the “disease” is probably more contagious for countries sharing similar weaknesses, rather than for healthy economies. What does the theory have to teach us? The budget-law is an annual law containing a detailed analysis of how much the government is seeking to collect (tax revenues) and to spend (public expenditure) in order to implement its political program in the reference year. The deficit is nothing more than the shortfall on the budget-law balance sheet, and it is going to be financed through debt. In other words, the deficit defined in the law determines by how much the primary sovereign debt[3]will increase next year. Is it a problem to fix a high deficit? Generally, it is not. But if a nation has a heavy and unsustainable debt on its shoulders, a further rise in this liability could bring, among creditors, uncertainty about the capability of the State to pay its debt back. That’s the famous default risk, on everyone’s lips during the “Greek Crisis”. As default risk become credible, investors need to be additionally rewarded for holding bonds issued by that State. In other words, the interest rate on national bonds moves inevitably up. At this point, as you can deduce, an unsustainable loop is generated: if the interest rate is higher, the interest burden will be higher and so will the debt; then the default risk will become even more credible and the interest rate will keep increasing again, letting the loop to start over. Thus a snowball effect is created.. Of course, this process is highly contagious, since a nation’s perceived solvency is deeply conditioned by the credibility of all the affiliated partners, especially those suffering from similar budgetary concerns. In order to prevent such a dangerous spiral, the European Commission has fixed a personalized upper-bound limit for the deficit of all the confederated nations whose debt is “problematic”[4]. Italy, for instance, with its public debt accounting for more than 131% of GDP, has been constrained to a maximum deficit spending equal to 0.8% of GDP.

[1] The European Commission letter of 5th October:

[2] The “chicken game”, in game theory, describes a scenario where two drivers drive towards each other on a collision course. One must turn the wheel, or both may die in the crash! Anyway, if one driver swerves and the other does not, the one who swerved will be called a “chicken”.

[3] The sovereign debt is made up by the core capital (gained from bond sales) and interests on such a capital. The primary sovereign debt consists only of the core capital component (without considering interests).

[4] According to the Maastricht Treaty, the EU nations should sustain a debt not higher than 60% of their GDP and fix an annual deficit within the 3% of GDP. As the debt constraint gets violated, the sustainable deficit happens to be revised downward.

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