Italy ponders IOU – Inflation On the Up

Tom Traill - 07 June 2018

Since 2010, Italy’s nominal GDP growth has tracked Germany’s almost perfectly: but around 200 basis points lower each year. After 8 years, this compounds to a 21 per cent shortfall. We can measure the cumulative income and output loss, after a fashion, but can only imagine the cumulative frustration and anger that has accompanied it. The new Italian government, sworn in on 1st June, has a reflationary mandate and can be expected to waste no time in pursuing this agenda.

Curious then, that the early reactions to the news of the formation of a populist government were that Italy would trigger a deflationary crisis in the Eurozone. If Italian bond prices were to plummet, then we can agree that Italy’s access to global capital markets would be impaired, bank deposits would be flooding out of the Italian banks into German banks and the European economy would be in turmoil. The new government will not accept the conditionality built in to the Outright Monetary Transactions programme. The ECB may find Italy’s petulance deeply irritating, but in the end, its overriding objective is the protection of the Eurozone financial system.

Likewise, the fiscal sanctions that the EU has at its disposal are ineffectual: the excessive deficit procedure has never been rigorously applied, thus far. There appears to be plenty of latitude for Italy to bend the European fiscal rules without breaking them. And Italy, which has run a primary budget surplus since 2012, cannot be accused of profligacy. The scope for a reflationary/inflationary departure in Italy has focused on its proposed use of a fiscal wheeze, known as mini-BOTs.

Described as a technical instrument capable of negotiating the EU’s loopholes, the mini-BOT is a low-denominated Treasury bill. The idea is that the Italian government securitizes its outstanding debt into non-interest-bearing coupons which can be redeemed against fiscal liabilities in the future. These IOUs circulate in settlement for goods and services within Italy, effectively stimulating domestic expenditures at the expense of international obligations (such as to the ECB). These mini-BOTs do not constitute a parallel currency, but could enjoy wide circulation. Some would say that they are helicopter money by a different name.

How different really would the dissemination of the mini-BOT be from the monetization of the national debt? Both infer a boost to spending power into the economy. It’s widely held that monetization would be inflationary, so it seems reasonable to imagine that the introduction of a load of government-backed quasi-money could be inflationary too. The potentially inflationary consequences would be compounded if a successful roll-out in Italy meant that the Greek, Spanish and Portuguese governments sought to replicate it.

It’s not just the mini-BoT that could stoke the inflationary coals. As more details become clear about the plans of the new government in Rome, it is apparent that the fiscal position is likely to worsen, with some estimates of the primary balance falling to between -2 and -4 per cent of GDP. However, nominal GDP would need to grow significantly faster to keep the public debt-GDP ratio in check.

The earlier Eurozone crisis had a deflationary bias; this one, should it develop, will end in fiscal relaxation, monetary expansion and inflation.

Figure 1

 Data source: CEIC

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