The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.
Italy is the third largest economy in the eurozone after Germany and France. Any serious economic weaknesses could have profound consequences for the rest of the eurozone and beyond.
At 135% of GDP, Italy’s public-sector debt is one the highest in the world; its banks are undercapitalised with a high proportion of bad debt; and it is still struggling to recover from the crisis of 2008–9. The Economist article elaborates:
The adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.
Since 2007, the economy has shrunk by 10%. And potential output has fallen too, as firms have closed. Unemployment is over 11%, with youth unemployment around 40%.
Things seem to be coming to a head. As confidence in the Italian banking system plummets, the Italian government would like to bail out the banks to try to restore confidence and encourage deposits and lending. But under new eurozone rules designed to protect taxpayers, it requires that the first line of support should be from bondholders. Such support is known as a ‘bail-in’.
If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.
So what is the solution? Italian banks need recapitalising to restore confidence and prevent a more serious crisis. However, there is limited scope for bailing in, unless small investors can be protected. And eurozone rules provide little scope for government funding for the banks. These rules should be relaxed under extreme circumstances. At the same time, policy needs to focus on making Italian banking more efficient.
Meanwhile, the IMF is forecasting that Italian economic growth will be less than 1% this year and little better in 2017. Part of the problem, claims the IMF, is the Brexit vote. This has heightened financial market volatility and increasead the risks for Italy with its fragile banking system. But the problems of the Italian economy run deeper and will require various supply-side policies to tackle low productivity, corruption, public-sector inefficiency and a financial system not fit for purpose. What the mix of these policies should be – whether market based or interventionist – is not just a question of effectiveness, but of political viability and democratic support.
Articles
The Italian Job The Economist (9/7/16)
IMF warns Italy of two-decade-long recessionThe Guardian, Larry Elliott (11/7/16)
Italy economy: IMF says country has ‘two lost decades’ of growth BBC News (12/7/16)
What’s the problem with Italian banks? BBC News, Andrew Walker (10/7/16)
Why Italy’s banking crisis will shake the eurozone to its core The Telegraph, Tim Wallace Szu Ping Chan (16/8/16)
If You Thought Brexit Was Bad Wait Until The Italian Banks All Go Bust Forbes, Tim Worstall (17/7/16)
In the euro zone’s latest crisis, Italy is torn between saving the banks or saving its people Quartz, Cassie Werber (13/7/16)
Why Italy could be the next European country to face an economic crisis Vox, Timothy B. Lee (8/7/16)
Forget Brexit, Quitaly is Europe’s next worry The Guardian, Larry Elliott (26/7/16)
Report
Italy IMF Country Report No. 16/222 (July 2016)
Data
Economic Outlook OECD (June 2016) (select ‘By country’ from the left-hand panel and then choose ‘Italy’ from the pull-down menu and choose appropriate time series)
Questions
- Can changes in aggregate demand have supply-side consequences? Explain.
- Explain why there may be a downward spiral of asset sales by banks.
- How might the principle of bail-ins for undercapitalised Italian banks be pursued without being at the expense of the small saver?
- What lessons are there from Japan’s ‘three arrows’ for Italy? Does being in the eurozone constrain Italy’s ability to adopt any or all of these three categories of policy?
- Why may the Brexit vote have more serious consequences for Italy than many other European economies?
- Find out what reforms have already been adopted or are being pursued by the Italian government. How successful are they likely to be in increasing Italian growth and productivity?
- What external factors are currently (a) favourable, (b) unfavourable to improving Italian growth and productivity?
Australia held a general election on 2 July 2016. The Liberal/National coalition narrowly won in the House of Representatives, gaining a substantially reduced majority of 77 of the 150 seats, to Labor’s 68 and other parties’ 5 seats. One campaign issue for all parties was the destruction of the Great Barrier Reef, which is seen as an environmental disaster. Each party had proposals for tackling the problem and we examine some of them here.
The Great Barrier Reef is the largest coral reef in the world. As the BBC’s iWonder guide states:
One of the world’s seven natural wonders, the Great Barrier Reef contains some 900 islands and 3000 smaller reefs. It is larger than the UK, the Netherlands and Switzerland combined, home to around 10% of the world’s marine fish, over 200 bird species and countless other animals, including turtles and dolphins.
But this iconic Reef system is facing unprecedented threats. Together with governments, scientists are playing a key role in the battle to preserve this vulnerable ecosystem before it’s too late.
The Reef is 2300km long. In the northern third, around half of the coral is dead. Few tourists see this, as they tend to dive in the southern third, which, being cooler, is less affected.
The bleaching and destruction of coral reefs has a number of causes. These include: rising water temperatures, generally from global warming and more extreme El Niño events (rising warm waters that periodically spread across the Pacific); pollution, including that from coal mining, industrial effluent and run-off of pesticides, herbicides, fertilisers and sediment from farming, leading to acidification of waters; more frequent and more violent cyclones; rapidly expanding numbers of coral-eating Crown of Thorns starfish; and over fishing of some species of fish, leading to knock-on effects on ecosystems.
The Barrier Reef and the oceans and atmosphere around it can be regarded as a common resource. The warming of the atmosphere and the oceans, and the destruction of the reef and the wildlife on it, are examples of the ‘tragedy of the commons’. With no-one owning these resources, they are likely to be overused and abused. Put another way, these activities cause negative externalities, which do not appear as costs to the polluters and despoilers, but are still costs to all who treasure the reef. And, from a non-human perspective, it is a cost to the planet and its biodiversity. What is in the private interests of the abusers is not in the social or environmental interest.
The Australian government had sought to downplay the extent of the problem, afraid of deterring tourists – a valuable source of revenue – and under pressure from the coal and farming industries. Nevertheless, in the run-up to the election, the destruction of the Reef and what to do about it became a major debating point between the parties.
The Coalition government has pledged A$1bn for a new Reef fund, which will be dedicated to tackling climate change and water quality.
The fund will also help coastal sewage treatment plants to reduce ocean outfalls with efficient pumps, biogas electricity generation and next-generation waste water treatment. Improving water quality will enhance the Reef’s resilience to climate change, coral bleaching and outbreaks of the destructive crown of thorns starfish.
But how much difference the fund can make with the money it will have is not clear.
The Labor Party pledged to follow every recommendation in the Great Barrier Reef Water Science Taskforce’s Final Report, released in May, and to pass laws to prevent farm pollution flowing into the waters around the Reef and to have a more rapid shift towards renewable energy.
The Green Party goes the furthest. In addition to the Labor Party’s proposals, it wants to impose taxes on coal firms equal to the cost of the damage they are causing. The tax revenues would be paid into a multi-billion dollar fund. This would then be spent on measures to rescue the Reef, invest in clean energy projects, stop damaging industrial development, improve farm management and stop polluted run-off into the Reef catchment area by investing in water systems.
Promises at the time of an election are all well and good. Just how much will be done by the re-elected Coalition government remains to be seen.
Interactive Videos and presentations
David Attenborough’s Great Barrier Reef: an Interactive Journey, Atlantic Productions, David Attenborough (2015)
Global Warming – the greatest market failure Prezi, Yvonne Cheng (5/12/12)
Articles
The Great Barrier Reef: a catastrophe laid bare The Guardian, Michael Slezak (7/6/16)
The Guardian view on the Great Barrier Reef: the crisis they prefer to downplay The Guardian (7/6/16)
Fight to save Great Barrier Reef could cost billions, secret government modelling estimates ABC News, Mark Willacy (2/6/16)
Great Barrier Reef: government must choose which parts to save, says expert The Guardian, Joshua Robertson (8/7/16)
This election, what hope is there for the Great Barrier Reef? The Guardian, Michael Slezak (1/7/16)
Coalition will protect Great Barrier Reef with $1bn fund, says PM The Guardian, Gareth Hutchens (12/6/16)
Great Barrier Reef election explainer: how do the parties compare? The Guardian, Michael Slezak (2/6/16)
Five things we can do right now to save the Great Barrier Reef The Guardian, John Pandolfi (13/6/16)
We’ve scored the parties on the Reef My Sunshine Coast, Australian Marine Conservation Society (29/6/16)
Our Most Iconic Places Are Under Dire Threat From Climate Change Huffington Post, Nick Visser (26/5/16)
There are bright spots among the world’s coral reefs – the challenge is to learn from them The Conversation, Australia, Joshua Cinner (21/7/16)
Questions
- Explain what is meant by the Tragedy of the Commons. Is all pollution damage an example of this?
- What can the Australian government do to internalise the external costs to the Great Barrier Reef from (a) farming; (b) mining; (c) global warming?
- Why is it difficult to reach international agreement on tackling climte change? What insights can game theory provide for understanding the difficulties?
- What are the recommendations in the Final Report of the Great Barrier Reef Water Science Taskforce? What mix of tools does it suggest?
- What are the relative advantages and disadvantages of taxation, laws and regulations, public investment, education and international negotiation as policy instruments to protect the Reef?
Since the Brexit vote in the referendum, sterling has been falling. It is now at a 31-year low against the US dollar. From 23 June to 6 July it depreciated by 12.9% against the US dollar, 10.7% against the euro and 17.0% against the yen. The trade-weighted sterling exchange rate index depreciated by 11.6%.
Why has this happened? Partly it reflects a decline in confidence in the UK economy by investors; partly it is in response to policy measures, actual and anticipated, by the Bank of England.
As far as investors are concerned, the anticipation is that there will be net direct investment outflows from the UK. This is because some companies in the UK are considering relocating part or all of their business from the UK to elsewhere in Europe. For example, EasyJet is drawing up plans to move its headquarters to continental Europe. It is also because investors believe that foreign direct investment in the UK is likely to fall as companies prefer to invest elsewhere, such as Ireland or Germany.
Thus although the effect of net direct investment outflows (or reductions in net inflows) will be on the long-term investment part of the financial account of the balance of payments, the immediate effect is felt on the short-term financial flows part of the account as investors anticipate such moves and the consequent fall in sterling.
As far as monetary policy is concerned, the fall in sterling is in response to four things announced or signalled by Mark Carney at recent news conferences (see Monetary and fiscal policies – a U-turn or keeping the economy on track?).
First is the anticipated fall in Bank Rate at the next meeting of the Monetary Policy Committee on 13/14 July. Second is the possibility of further quantitative easing (QE). Third is an additional £250bn of liquidity that the Bank is prepared to provide through its normal open-market operations. Fourth is the easing of capital requirements on banks (reducing the countercyclical buffer from 0.5% to 0%), which would allow additional lending by banks of up to £150bn.
Lower interest rates, additional liquidity and further QE would all increase the supply of sterling on the foreign exchange markets. The anticipation of this, plus the anticipation of lower interest rates, would decrease the demand for sterling. The effect of these supply and demand changes is a fall in the exchange rate.
But is a fall in the exchange rate a ‘good thing’? As far as consumers are concerned, the answer is no. Imports will be more expensive, as will foreign holidays. People’s pounds will buy less of things priced in foreign currency and thus people will be poorer.
As far as exporters are concerned, however, the foreign currency they earn will exchange into more pounds than before. Their sterling revenues, therefore, are likely to increase. They might also choose to reduce the foreign currency price of exports, thereby increasing the quantity sold – the amount depending on the price elasticity of demand. The increase in exports and reduction in imports will help to reduce the current account deficit and also boost aggregate demand.
Articles
Pound slumps to 31-year low following Brexit vote The Guardian, Katie Allen , Jill Treanor and Simon Goodley (24/6/16)
Sterling’s post-Brexit fall is biggest loss in a hard currency Reuters, Jamie McGeever (7/7/16)
Brexit Accelerates the British Pound’s 100 Years of Debasement Bloomberg, Simon Kennedy and Lukanyo Mnyanda (5/7/16)
Pound sterling falls below $1.31 hitting new 31-year low Independent, Hazel Sheffield (5/7/16)
Viewpoints: How low will sterling go? BBC News, Leisha Chi (6/7/16)
How low will the pound fall? Financial Times (7/7/16)
Allianz’s El-Erian says UK must urgently get its act together or dollar parity could beckon Reuters, Guy Faulconbridge (7/7/16)
What does a falling pound mean for the British economy? The Telegraph, Peter Spence (6/7/16)
Data
Spot exchange rates: Statistical Interactive Database – interest & exchange rates data Bank of England
Questions
- What determines how much the exchange rate depreciates for a given shift in the demand for sterling or the supply of sterling?
- Why might the short-term effects on exchange rates of the Brexit vote be different from the long-term effects?
- Why has the pound depreciated by different amounts against different currencies?
- What are likely to be the effects on the financial and current accounts of the balance of payments of the Bank of England’s measures?
- Find out what has happened to business confidence since the Brexit vote. What effect does the level of confidence have on the exchange rate and why?
Before the referendum, economists overwhelmingly argued that the economic case for the UK remaining in the EU was much stronger than that for leaving. They warned of serious economic consequences, both short term and long term, of a Brexit vote. And yet, by a majority of 51.9% to 48.1% of the 72.1% of the electorate who voted, the UK voted to leave the EU.
Does this mean that economists failed to communicate to the electorate? Were the arguments presented poorly or in too academic a way?
Or did people simply not believe the economists’ forecasts, being cynical about the ability of economists to forecast? During the campaign, on several occasions I heard people repeating the joke that economists had successfully predicted five out of the last two recessions!
Did they not believe the data that immigrants from other EU countries to the UK contribute more in taxes they draw in benefits and that overall they make a net positive contribution to output per head? Or perhaps they believed the claims that immigrants imposed a net cost on the economy.
Or were there ‘non-economic’ issues that people found more persuasive, such as questions of sovereignty or national identity? Or was the strain on local resources, such as health services, schools and housing, blamed on immigration itself rather than on a lack of spending on additional resources – the funding for which could have come from the extra GDP generated by the immigration?
Or were there so many lies told by politicians and those with vested interests that people simply didn’t know whom to believe?
Economists will, no doubt, do a lot of soul searching over the coming months. One such economist is Paul Johnson, Director of the Institute for Fiscal Studies, whose article is linked below.
Article
We economists must face the plain truth that the referendum showed our failings Institute for Fiscal Studies newspaper articles. Paul Johnson (28/6/16)
Questions
- In what ways could economists have communicated better to the general public during the referendum campaign?
- For what reasons may people distrust economists?
- Were economists hampered in delivering their message by ‘balanced reporting’?
- Comment on Paul Johnson’s statement that, ‘The most politically engaged of us spend decades working out how to tweak tax policy, or labour market policy, or competition policy to deliver small benefits. How many times over would our work have been repaid if we had simply convinced a few more people of the basics?’
- Do economists, or at least some of them, need to become more ‘media savvy’?
- How could institutions, such as the Royal Economic Society and the Society of Business Economists, do more to help economists collectively to communicate with the general public?
- Give some examples of the terminology/jargon we use which might be inappropriate for communicating with the general public. Suggest some alternative terms to the examples you’ve given.
What have been, and will be, the monetary and fiscal responses to the Brexit vote in the referendum of 23 June 2016? This question has been addressed in speeches by Mark Carney, Governor of the Bank of England, and by George Osborne, Chancellor the Exchequer. Both recognise that the vote will cause a negative shock to the economy, which will require some stimulus to aggregate demand to avoid a recession, or at least minimise its depth.
Mark Carney stated that:
The Bank of England stands ready to provide more than £250bn of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required.
In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses.
This could mean that at its the next meeting, scheduled for 13/14 July, the Monetary Policy Committee will consider reducing Bank Rate from its current level of 0.5% and introducing further quantitative easing.
In a speech on 30 June, he went further:
I can assure you that in the coming months the Bank can be expected to take whatever action is needed to support growth subject to inflation being projected to return to the target over an appropriate horizon, and inflation expectations remaining well anchored.
Then in a speech on 5 July, introducing the latest Financial Stability Report, he said that the Bank of England’s Financial Policy Committee is lowering the required capital ratio of banks, thereby freeing up capital for lending to customers. The part being lowered is the ‘countercyclical capital buffer’ – the element that can be varied according to the state of the economy. Mark Carney said:
The FPC is today reducing the countercyclical capital buffer on banks’ UK exposures from 0.5% to 0% with immediate effect. This is a major change. It means that three quarters of UK banks, accounting for 90% of the stock of UK lending, will immediately have greater flexibility to supply credit to UK households and firms.
Specifically, the FPC’s action immediately reduces regulatory capital buffers by £5.7 billion and therefore raises banks’ capacity to lend to UK businesses and households by up to £150 billion. For comparison, last year with a fully functioning banking system and one of the fastest growing economies in the G7, total net lending in the UK was £60 billion.
Thus although there may be changes to interest rates and narrow money in response to economic reactions to the Brexit vote, the monetary policy framework remains unchanged. This is to achieve a target rate of CPI inflation of 2% at the 24-month time horizon.
But what of fiscal policy?
In its Charter for Budget Responsibility, updated in the Summer 2015 Budget, the government states its Fiscal Mandate:
3.2 In normal times, once a headline surplus has been achieved, the Treasury’s mandate for fiscal policy is:
• a target for a surplus on public-sector net borrowing in each subsequent year.
3.3 For the period outside normal times from 2015-16, the Treasury’s mandate for fiscal policy is:
• a target for a surplus on public-sector net borrowing by the end of 2019-20.
3.4 For this period until 2019-20, the Treasury’s mandate for fiscal policy is supplemented by:
• a target for public-sector net debt as a percentage of GDP to be falling in each year.
The target of a PSNB surplus by 2019-20 has been the cornerstone of recent fiscal policy. In order to stick to it, the Chancellor warned before the referendum that a slowdown in the economy as a result of a Brexit vote would force him to introduce an emergency Budget, which would involve cuts in government expenditure and increases in taxes.
However, since the vote he is now saying that the slowdown would force him to extend the time for reaching a surplus beyond 2019-20 to avoid dampening the economy further. But does this mean he is abandoning his fiscal target and resorting to discretionary expansionary fiscal policy?
George Osborne’s answer to this question is no. He argues that extending the deadline for a surplus is consistent with paragraph 3.5 of the Charter, which reads:
3.5 These targets apply unless and until the Office for Budget Responsibility (OBR) assess, as part of their economic and fiscal forecast, that there is a significant negative shock to the UK. A significant negative shock is defined as real GDP growth of less than 1% on a rolling 4 quarter-on-4 quarter basis. If the OBR assess that a significant negative shock:
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occurred in the most recent 4 quarter period; |
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is occurring at the time the assessment is being made; or |
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will occur during the forecast period |
then:
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if the normal times surplus rule in 3.2 is in force, the target for a surplus each year is suspended (regardless of future data revisions). The Treasury must set out a plan to return to surplus. This plan must include appropriate fiscal targets, which will be assessed by the OBR. The plan, including fiscal targets, must be presented by the Chancellor of the Exchequer to Parliament at or before the first financial report after the shock. The new fiscal targets must be approved by a vote in the House of Commons. |
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if the shock occurs outside normal times, the Treasury will review the appropriateness of its fiscal targets for the period until the public finances return to surplus. Any changes to the targets must be approved by a vote in the House of Commons. |
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once the budget is in surplus, the target set out in 3.2 above applies. |
In other words, if the OBR forecasts that the Brexit vote will result in GDP growing by less than 1%, the Chancellor can delay reaching the surplus and thus not have to introduce tougher austerity measures. This, in effect, is what he is now saying and maintaining that, because of paragraph 3.5, it does not break the Fiscal Mandate. The nature of the next Budget, probably in the autumn, will depend on OBR forecasts.
A few days later, George Osborne announced that he plans to cut corporation tax from the current 20% to less than 15% – below the rate of 17% previously scheduled for 2019-20. His aim is not just to stimulate the economy, but to attract inward investment, as the rate would below that of any major economy and close the rate of 12.5% in Ireland. His hope would also be to halt the outflow of investment as companies seek to relocate in the EU.
Videos and podcasts
Statement from the Governor of the Bank of England following the EU referendum result Bank of England (24/6/16)
Uncertainty, the economy and policy – speech by Mark Carney Bank of England (30/6/16)
Introduction to Financial Stability Report, July 2016 Bank of England (5/7/16)
Osborne: Life will not be ‘economically rosy’ outside EU BBC News (28/6/16)
Osborne takes ‘realistic’ view over surplus target BBC News (1/7/16)
Why has George Osborne abandoned a key economic target? BBC News (1/7/16)
Articles
Mark Carney says Bank of England ready to inject £250bn into economy to keep UK afloat after EU referendum Independent, Zlata Rodionova (24/6/16)
Carney Signals Rate Cuts as Brexit Chaos Engulfs Political Class Bloomberg, Scott Hamilton (30/6/16)
Bank of England hints at UK interest rate cuts over coming months to ease Brexit woes International Business Times, Gaurav Sharma (30/6/16)
Carney prepares for ‘economic post-traumatic stress’ Financial Times, Emily Cadman (30/6/16)
Bank of England warns Brexit risks beginning to crystallise BBC News (5/7/16)
Bank of England tells banks to cut buffer to boost lending Financial Times, Caroline Binham and Chris Giles (5/7/16)
George Osborne puts corporation tax cut at heart of Brexit recovery plan Financial Times (3/7/16)
George Osborne corporation tax cut is the wrong way to start EU negotiations, former WTO boss says Independent, Hazel Sheffield (5/7/16)
George Osborne abandons 2020 UK surplus target Financial Times, Emily Cadman and Gemma Tetlow (1/7/16)
George Osborne scraps 2020 budget surplus plan The Guardian, Jill Treanor and Katie Allen (1/7/16)
Osborne abandons 2020 budget surplus target BBC News (1/7/16)
Brexit and the easing of austerity BBC News, Kamal Ahmed (1/7/16)
Osborne Follows Carney in Signaling Stimulus After Brexit Bloomberg, Simon Kennedy (1/7/16)
Questions
- Explain the measures taken by the Bank of England directly after the Brexit vote.
- What will determine whether the Bank of England engages in further quantitative easing beyond the current £385bn of asset purchases?
- How does monetary policy easing (or the expectation of it) affect the exchange rate? Explain.
- How effective is monetary policy for expanding aggregate demand? Is it more or less effective than using monetary policy to reduce aggregate demand?
- Explain what is meant by (a) capital adequacy ratios (tier 1 and tier 2); (b) countercyclical buffers. (See, for example, Economics 9th edition, page 533–7 and Figure 16.2))
- To what extent does increasing the supply of credit result in that credit being taken up by businesses and consumers?
- Distinguish between rules-based and discretionary fiscal policy. How would you describe paragraph 3.5 in the Charter for Budget Responsibility?
- Would you describe George Osborne’s proposed fiscal measures as expansionary or merely as less contractionary?
- Why is the WTO unhappy with George Osborne’s proposals about corporation tax?
- What is the Nash equilibrium of countries seeking to undercut each other’s corporation tax rates?
The Brexit vote has caused shockwaves throughout European economies. But there is a potentially larger economic and political problem facing the EU and the eurozone more specifically. And that is the state of the Italian banking system and the Italian economy.
If bondholders were large institutional investors, this might not be such a problem, but a significant proportion of bank bonds in Italy are held by small investors, encouraged to do so by tax relief. Bailing in the banks by requiring bondholders to bear significant losses in the value of their bonds could undermine the savings of many Italians and cause them severe hardship, especially those who had saved for their retirement.
