ECB has an Italy problem, and vice versa: James Saft

August 12, 2014

By James Saft

(Reuters) – (James Saft is a Reuters columnist. The opinions expressed are his own)

Italy’s recession is a neat illustration not just of the unrelenting pressure on the European Central Bank to take radical steps to stave off deflation, but of why those steps may well work poorly.

Data last week showed the Italian economy contracting for the second straight quarter in April through June, entering its third recession since 2008, and a possible sign of the early and incomplete effects of sanctions against Russia.

Not only does Italy face fallout from the Russia/Ukraine fracas, notably a drop in demand for its luxury goods, but it is also hamstrung by poor demographics and efforts to enact economic reforms will be slowed by its famously intransigent political process.

This reality, in combination with a sobering fall in German industrial orders, raised expectations – fruitlessly, as it turned out – that the ECB would at its policy meeting last week move forward much-debated proposals to begin quantitative easing by buying up asset-backed bonds. The ECB instead chose to temporize, announcing it was in the process of hiring a consultant to help it design such a program and the market changes which it says would need to accompany it.

The backdrop here is that despite this talk, and the ECB having unveiled in June a raft of policy measures, the market is showing an alarming lack of faith in either its ability or willingness to arrest the euro zone’s fall in inflation, which now stands at just 0.4 percent. While the ECB takes comfort from what consumers say they expect inflation to be over the long term, a look at expectations as expressed in the bond markets shows a different picture.

Not only are Italian bond prices showing an expectation of outright deflation over one year, similar prices for three- and five-year inflation have moved lower in recent months for major economies such as Germany and France. 

A lot of this doubt may be because of structural issues over which the ECB has only limited control. Quantitative easing is a deeply divisive issue in the euro zone, bringing up thorny issues about how the ECB would divide up the stimulus among member states. As well, compared to the U.S., the market which would create the asset-backed bonds the ECB would buy is small and thinly traded, making a rapid acceleration in purchases difficult.


All else being equal one would expect that not only would the ECB move smartly ahead with quantitative easing, but that it would direct more of the force of its asset buying at economies like Italy which are struggling the most.

All else of course is rarely equal, and there is good reason to think the ECB does not want the pace of its support for the weakened economies to exceed that of the structural reforms it has so often argued for. Do too much on the monetary policy side and perhaps those needed reforms never arrive. That’s a sensible game tactic, but one with impact on several players on the fringes of the game. Investors rightly see this as delaying and diluting the stimulus. Their bets in financial markets, in turn, will eventually dampen medium- and longer-term consumer expectations.

Italian Prime Minister Matteo Renzi has chosen to prioritize constitutional reforms, arguing that if achieved they will bring political stability which will allow for faster economic reforms. He may well succeed but what is clear is that the process will be slow and halting and potentially involve a referendum.

The pace of reforms has contributed to the recession, Societe Generale economist Yacine Rouimi argues.

“Progress on structural reforms, as well as on institutional reforms (Senate reform and electoral law), has been limited since prime minister Renzi came to power in March. The result is a drop in confidence, acting as a strong disincentive for businesses to invest and hire,” he wrote in a note to clients.

An index of economic policy uncertainty, which had been falling since Renzi came to power in March, recently began to rise again, underlining just how tough a fight he faces.


And the problem with recessions is that they ruin budgets, cutting tax receipts and raising other calls on the treasury. Based on a forecast of 0.2 percent contraction for the full year, Socgen’s Rouimi sees a public deficit in Italy of 3.4 percent this year, above the 3.0 percent limit. That brings with it its own risks, as Renzi may be forced to pass a new budget, which like all contractionary budgets in a recession will be politically unpopular and may be stymied.

Both Italy and the ECB suffer from structural weaknesses, all of which serve to weaken both and make both less effective.

Quantitative easing, if it comes, won’t change that.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns at

(Editing by James Dalgleish)

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