The Economist Paul Pasquariello he has been the new head of the finance department at the University of Michigan for a few days. From the prestigious Stephen M. Ross chair of the School of Business, he looks carefully at what is happening around the policy and Italian public finance. «The USA has entered the last kilometer of the midterm elections. Media attention is focused almost exclusively on the probable handover from Democrats to Republicans in Congress and on the criminal vicissitudes of former President Trump. In this climate, the war in Ukraine, the political crisis in the UK and the Italian elections are receiving little attention. Maybe it's better this way".
Italy's elections come amid an energy war and with inflation approaching double-digits. Is there a return of an "Italy risk" for the eurozone?
«The markets are experiencing a period of great uncertainty and turbulence, dynamics that have no direct origin in the "Italy risk". The last global pandemic dates back to the end of the First World War. The last extensive territorial war in Europe dates back to the end of the Second World War. None of today's financial operators has any direct memory of these events and above all any direct experience of the reaction of the markets in similar situations".
However, the major global sovereign debt issuers are not all in the same position of strength.
«In a situation of systemic volatility, it is not surprising that more “fragile” countries and financial assets come under pressure. Investors seek refuge in safer investments after abandoning riskier ones. The "flight to quality" or "flight to safety" leads to a widening of the spread between Italian and German government bonds. In addition, US government bonds, classic safe-haven assets, are beginning to offer attractive yields (despite the strong dollar), in response to the Federal Reserve's restrictive monetary policy. This is where the unfavorable picture for Italian sovereign bonds becomes complete».
What financial scenarios could bring Italian bonds back under market pressure?
«There is a particular aspect of the Italian bond markets that ends up attracting more adverse speculation during moments of tension. In fact, they are among the most liquid markets ever, probably second only to US sovereign bonds. Liquidity is a quality that attracts investors a lot. However, during stormy times, liquidity also favors a faster and more convenient exit than other markets. Given the same political uncertainty (for example in the United Kingdom, in France or even in Germany), this condition of liquidity therefore ends up making Italian securities more sensitive to events that are often not very connected to our political vicissitudes».
The ECB expects a path to increase interest rates faster than estimated in recent months. Is this the right way to stem this season of inflation in Europe?
«It is a right and obligatory choice. Until now, the ECB has acted much more cautiously and less aggressively than the Fed, for reasons related to the aftermath of the Russian invasion of Ukraine. Inflationary pressures are beginning to be very significant, not only due to the energy crisis but also due to the progressive weakening of the euro, mainly against the dollar but not only. Eventually, the ECB will be forced to raise interest rates quickly, both to mitigate stagflation (anemic or negative growth and high inflation) and to stabilize the euro. Unfortunately, difficult times await us in Europe».
Will Italy have to review the ambition of its economic programs?
«In conditions of weakness of the euro it is difficult to think that European states can afford to maintain large current budget deficits. The cost of refinancing existing debt and new debt is rising and will continue to rise. These circumstances will greatly limit the fiscal space for any successor government to Draghi. In this sense, the phantasmagorical fiscal promises of these days are running out of time. Any responsible government that emerges from the elections will not have more room for maneuver than previously available to the Draghi government.
The sustainability of the Italian debt is also largely linked to confidence in the reliability of our economic policies. Are fiscal measures such as the flat tax sustainable for an economy like the Italian one?
«I'm not speaking on behalf of international speculators (God forbid), but it is clear to any self-respecting economist that any measure that produces a dramatic reduction in the tax burden - and the flat tax is one of these - will have as its first result the explosion of the deficit. The idea that reducing the tax burden generates more economic activity that more than compensates for the reduction in revenues is fanciful and indefensible. To date, there is no country in the world where such an idea has ever worked".
The flat tax is in the programme, albeit with different rates, of the centre-right parties, a coalition considered to be the winner in all the polls.
“The Laffer curve, as the idea that cutting taxes increases revenues is called, exists only in the imagination of its inventor. It is no coincidence that here in the USA the fiscal deficit tends to explode during republican administrations, that is, under governments with an easy fiscal gap. It's really hard for me to think that a government of any color could be irresponsible enough to implement a tax policy of well-known and failed outcome. I have long since stopped taking electoral promises seriously, both in the USA and in Italy. That said, there is ample evidence of irresponsible governments, across the Atlantic Ocean, and it is no surprise that some of these promises are reaching the ears of the markets and intimidating investors already ready to divest. Italian securities".
Do you think that Italy can renegotiate parts and timing of the PNRR without creating deep political fractures with the EU?
«The political and economic room for maneuver for Italy is somewhat limited at the moment. It was true for Prime Minister Draghi, despite his enormous international credibility, and it will remain true for anyone who takes his place, especially if he lacks such credibility. Basically: it doesn't seem possible at all to me.
What are your forecasts for inflation in the eurozone?
«It will take a long time before the target of 2% average inflation in the eurozone can be achieved. While the ECB will never openly admit it, in an attempt to manage medium- to long-term inflationary expectations and not disappoint Northern European hawks, it would hardly surprise me if many of the internal analyzes of the various monetary policy options available are not already based on medium-term average inflation rates of at least 3-4%'.
The eurozone, caught between crazy energy prices and rising rates, is set to slip into recession. An "induced" and controllable recession or with risks that we are not yet able to weigh?
«I start from the Fed over which hangs the very sword of Damocles in the fight against inflation. Despite a more favorable economic situation compared to the European Union, many economists still doubt that the Fed will succeed in a soft landing, ie a rapid reduction in inflation accompanied by only slowed growth. Many hope that the inevitable recession, albeit severe, will be short-lived and will be partially mitigated by recent fiscal initiatives on growth and the environment. For Europe, it is difficult for me to imagine that, given a much more unfavorable macroeconomic situation and the presence of several external sources of economic stress, the ECB will be able to obtain a soft landing».
Is this the explanation of the exchange rate between the euro and the dollar?
“Markets have long since reached this conclusion. The weakness of the euro only contributes to a worsening of the European inflationary situation. Looking ahead, a desirable scenario would be one in which the US emerges from this phase before the EU: the Fed would start cutting interest rates, making European sovereign bonds more attractive and leading to an appreciation of the euro. This appreciation would help to ease inflationary pressures, while the nascent US recovery could stimulate demand in Europe as well».
And then there is the war.
"Exact. How long will the brutal invasion of Ukraine last? With what result will the conflict end? Will there be economic reparations for Ukraine given the massive damage inflicted by Russian bombing? Will the energy markets return to normal?
