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2 Senseless Statements Can Imply Interesting Policy Advice

An Italian government bond yield of four percentage points over the German bund, coupled with zero real gross domestic product growth, could prove “explosive” for the country, although a spread of 1.5 percentage points and growth of 1.5% would leave the country solvent, Fitch said.

Two things come immediately to my mind after reading this statement on Italy by the rating agency Fitch.

First, we are in the Fitch explosion scenario, with a recession above -1% of GDP and a spread above 4% of the Bund yield. We did not explode yet, did we? Where do these numbers come from? What economic theory underpins them? And what does “could prove” mean? This is poor economics unworthy of a rating agency.

Similarly poor is the reference to a spread of 1,5% and growth of 1,5% as a safe harbor. What if Bund rates were to jump above, say, 3%? Would an Italian 4,5% interest rate and an Italian growth rate of 1,5% prove sustainable? I dont know. But I am sure Fitch too does not know how to prove that statement.

From two senseless statements however a miracle can come out and an interesting thought can arise. Indeed, whatever the numbers put out by Fitch, the logic they seem to generate is one that the divide between an explosion and solvency is: lower spreads and higher growth.

Now how can you achieve in Italy lower spreads and higher growth? 3 possible ways:

a) lower spreads allow higher growth;

b) higher growth reduces spreads;

c) lower spreads and higher growth are both caused by a third factor.

a) would imply some sort of an investment-driven growth through lower rates of interest. But it remains silent as to the causes of lower spreads.

b) would imply some sort of confidence-driven spread collapse through higher growth. But it remains silent as to the causes of higher growth.

c) makes sense. Two things might generate this for Italy: a sudden burst of world economic growth in an export-driven recovery or the sudden adoption of smart economic policies in a demand or supply-driven recovery. Since one can safely exclude that world economic growth will save Italy next year, we are left with only two possible solutions.

A supply-generated Italian recovery through reforms or a demand-generated recovery through expansive fiscal policy; and from either one of these 2 policies a spread decline would follow thanks to a confidence effect due to better Italian fundamentals.

So now, please tell me, what can generate a recovery from -1% to 1,5% of GDP growth in a brief period (1 year)? Supply-side reforms of the cab-drivers, work-flexibility clauses, opening for longer hours shops? Allow me to smile. This is another senseless statement.

We are left with the obvious that the European consensus denies with sad masochism: only huge demand-side expansive fiscal policy can lead to a pick-up of growth (hardly of an improvement of 2,5% though) and a decline of spreads.

This implies Mr. Monti banging his fist at the negotating table for the new EU treaty and threatening his veto to any proposal that implies fiscal austerity for Italy, only because this would imply, according to Fitch that is, the death of Italy in the euro area and thus of the euro itself.

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