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Italy’s PM Mario Monti is in South Korea this week for the nuclear security summit. This marks Monti’s main foray outside the economic arena into the world diplomatic and security scene. Today he has met with President Obama who complimented him for his economic leadership not only of the Italian economy, but also for his contribution to solving the European financial crisis. This is no mean feat. Italy’s two Marios have risen to the top of European policy making in the last six months and have turned Italy from the weak link to a main architect of the resolution of the crisis that at one point had put the entire European integration at risk. We are not surprised that Monti is held in such esteem abroad. What is more surprising and in some ways unique, is the popularity that Monti is enjoying in Italy after less than six months in power, months during which he had to push through some of the most aggressive fiscal and reform packages in Italy’s modern history.

Apart from two fringe populist parties, and possibly the most left leaning union, Monti is enjoying very wide support from the main political parties on the right and the left, from the public, and from the unions and manufacturers associations (in Italy they are called ‘le parti sociali’). It is likely that Monti’s political adventure will be case study material in future decades about the fact that when a political leader has integrity and personal credibility, he can afford to impose bitter medicines to his citizens and remain very popular. It is unlikely that Monti will want to stay past the 2013 elections, but if he wanted to it would be very difficult to beat his quiet, confident style.

Two legged stools are not very stable and Monti’s ascension to European prominence is a good thing for Italy and for Europe as a whole. While Sarkozy is fighting a difficult battle for re-election and Merkel is trying to manage the ideological concern that post-war Germany has over becoming again Europe’s leading nation, not with guns but with money this time, Mr Monti has used his prestige and his impeccable European record to start changing the European discourse towards growth. This will not be an easy battle since Germany’s aversion to easy money is even older than its fear of leading Europe, but it is a beginning.

As a seasoned economist, and as the prime minister of a nation that has practically stopped growing ten years ago, Monti knows full well that fiscal constraints can only do so much to reduce debt. Having done a lot of work on the nominator, it is now time to work on the denominator. The problem with a growth strategy is that in the past nations have abused the concept and the result has been more debt and not a lot of sustainable growth. Italy is trying to square the circle acting along three axes. The first was the emergency budget approved before the turn of the year, which in effect ensured a current account surplus one year ahead of the Berlusconi-Tremonti plans,  which had already done a lot to keep Italy’s finances in better shape than most other economies. The problem was and is growth, the second driver of the plan. Berlusconi had already insisted on a lot of the liberalisation and flexibility measures advocated now by Monti, but wasn’t able to implement them due to Tremonti and his fragmented coalition. Monti has a better shot at it because of his economic credibility and because Italy has now stared into the abyss and presumably the Italians shouldn’t want to go back there. Growth measures are expensive, and achieving a flexible economy is difficult because of the remaining power of Italy’s unions and the ideological difficulty in getting rid of the famous Art.18, which stipulates that companies with over fifteen employees cannot lay off workers. To pay for growth and to show equanimity, Monti is using the tax axe, directing it mainly against ‘the rich’. With newspaper headlines recounting juicy stories about owners of Ferraris and Lamborghinis being caught by the tax police with reported incomes barely enough to pay for the petrol, Monti is achieving two things: first, he should start raising the taxable basis, as Italians learn that they cannot have sports cars and yachts without a demonstrable income; second, he will be able to tell the unions and the working class who is dead scared about labour flexibility, that ‘also the rich cry’, to paraphrase the name of an old Brazilian soap opera.

While every country has its own history and its own particular dynamics (this is the problem with the one size fit all euro area which hasn’t been solved, and may not be solvable…), Italy’s plans can serve as a template for other countries as well. Greece for example, needs a tectonic change in the mind-set of its citizens that need to understand that you cannot have a welfare state without paying substantial amounts of tax. France, on the other hand, and this is also a lesson that other countries, should understand, should be careful with its tendency to over tax to pay for the generous and efficient welfare state that its citizens have come to expect. The continent wide tendency to increase higher rate taxes to over 50% and sometime up to 75% has been proven in the past to backfire. It may serve as a populist tool, but it doesn’t raise tax revenue.

However,  effective this year, new anti-avoidance measures coupled with a new ‘fanatic’ enforcement mentality (which has emptied Italian ski resorts of high end skiers, and ports of super yachts—both types cautiously moving to Switzerland and France, respectively) the time tested pragmatic approach of over taxing knowing that taxpayers will under report, is not working anymore. To adjust, the government will need to aggressively cut taxes to avoid a huge crowding out effect generated by the fiscal tightening, which has increased both the taxable base and some of the actual headline rates. For example, IRAP, the tax that is effectively levied on turnover rather than profits was a temporary measure to circumvent business owners that always reported low incomes or losses. This tax, whose constitutionality and fairness was repeatedly challenged, has been marginally reduced by the government at the end of last year, but it must be scrapped entirely as a first measure to reconcile headline taxes with the need to provide oxygen for growth to the economy.

In addition, the government has promised a lot in terms of liberalising the economy, but to date, apart from the famous war with the taxi drivers, has accomplished quite little. The real test will come with labour market reforms, a very hot subject in Italy. Italian experts in this field are forced to live under police escort, given that their most prominent colleagues have been threatened, shot, and even killed. Italy’s labour laws famously defend only the employed at the expense of the young and the unemployed in general. Unless Italy gathers the force and the courage to make the country a better place to do business where you don’t have to pay taxes on losses, and are not afraid to hire because employees become a catholic marriage partner, no fiscal tightening will help to lower Italy’s high ratio of government debt to GDP which is still hovering well above 100%.

This week I was quoted in an article by Tony Griffiths for HFMWeek about the hedge fund industry’s fee structures. Please visit the article to view my opinion.

Pending the unloading of the real bazooka that the market has been expecting from Angela Merkel, the ECB has decided to fight for time by propping up the banks through the LTRO. This course of action displaces private activity and is producing several distortions. Let’s look at a few of the most significant ones. Firstly, together with the stated QE policy of the Fed and the BOE, it is keeping short rates (and in the US and UK also long rates) very low, amidst a torrent of liquidity. However, the chain of transmission has stopped working, and these banks are not passing on their cheap funding to corporate clients. They are doing two things with the ECB funds; either they hoard it for fears of rainy days, or they use the funds to invest in government bonds that yield many hundreds of basis points more than their funding, even for short term issues, thus pocketing a substantial spread. The problem with this seemingly simple strategy is that if any of these governments were to default or restructure, they would be compounding their problems, given that the very problem that most of these banks are tackling is the high proportion of government bets among their assets.

Following on the tradition of previous EU summits, last week’s event proved to be a letdown for those who have been hoping for the Germans and the ECB to start working on an effective solution that would give immediate gratification to the financial markets. What they got instead was a roadmap to a political long term solution based on a moderate relinquishment of sovereignty to ensure that failure to abide by the budget rules would have ‘automatic’ consequences. The problem is that such an outcome would have been great nine, six, and maybe even three months ago, but with today’s degree of scepticism, it is far from clear that these political horizons will satisfy anybody, let alone the markets, which indeed reacted negatively.

No wonder that Cameron chose to use the veto red button that is meant to be there for leverage not to be actually used. By using the veto Cameron has basically lost the leverage. Just like the US Republicans have found lawyerly ways to go around the automatic government expense reduction agreement to protect for example, defence, the EU, with Sarkozy’s leadership, will find crafty ways to go around the UK veto while at the same time marginalising his British cousins. But Cameron thought that if there is a time to be wary of more Europe, it is now! Who wants to jump into a sinking ship? This is not a good sign…

Just as we discussed last week, Monti has delivered a tough but fair budget which comprises both tax savings and incentives (the deductibility of the horrible IRAP tax is certainly welcome and long overdue). Has he done enough? Probably not, but in only just over a couple of weeks in office, this can be considered a very serious achievement.

Interestingly, Monti has described his Emergency Budget as a Save Italy bill. While Monti couldn’t say it given that he needs their votes, the last famous times that parliament voted save-something bills was to save Berlusconi’s TVs from being put off the air.  This time, Monti said, we need to save Italy, and indirectly, the entire Euro endeavour. Will it do the job? Well, the markets clearly liked it a lot, sending the infamous BTP-Bund spread well below 400bps from a high of nearly 550bp four weeks ago.

But the ball is now back with Sarkozy and Merkel, and later on this week with the other Euro zone members, who will need to show Draghi that they have done all they can on the political front and give him a green light to use the Bazooka, given that, this must be made clear, he is the only one who has the technical means to execute instantaneously. The method is probably the one we have discussed before: a SSB  style statement saying that the ECB will not tolerate yields on certain government bonds to trade above a stated limit.

We would like to add one caveat to this. While the SSB’s methods have worked brilliantly, and just the announcement worked its magic, Draghi knows that at this late stage in the crisis he must be ready to confront the market for real if he is tested. This test will probably come at some later stage, when some hiccups will start emerging on the political front. Let us hope that this weekend will see serious and actionable decisions.

The standard narrative in Italy is that the advent of the Euro saved the Italian economy. Three standard reasons are given: the Lira kept on being targeted by speculators and its peg to the ECU and DM had to be devalued on a semi-regular basis; the conditions for joining the club, which were imposed by the Prodi-Amato administration forced Italian finances to become more virtuous; and finally, the lower cost of borrowing would have allowed the budget deficit and the cost of servicing the stock of debt much lower.

Most of the above benefits did indeed take place for most of the previous decade, which saw record low borrowing rates, primary budget surpluses, and a conservative approach to government spending post the Lehman crisis which meant that Italian finances didn’t appreciably deteriorate after 2008, unlike the United States’ and the UK’s, for example.

However,  and counter intuitively, the price paid for these virtues was a transfer of wealth from the productive areas of society which stopped growing as unit labour costs went up in absolute and relative terms and made Italy less competitive, to the ‘rentiers’, which had lower nominal returns on their fixed income portfolios, but enjoyed an incredible appreciation in the value of their real assets. These effects are easily spotted: Italy barely grew in the last decade, as a strong currency made it less competitive vis a vis not only China, but also Germany, but the price of a square meter of prime real estate in Rome and Milan is now in the same league of London and Paris, and certainly higher than Frankfurt and Berlin.

The fair way to deal with this problem, which we understand Mr. Monti  ‘gets’, is to reduce taxation on the productive part of the economy, by lowering payroll taxes, and making the labour market more flexible, and at the same time taxing big property wealth and increasing the pensionable age. These measures would have a combined effect of reducing youth unemployment, reducing unit labour costs, increasing consumption, and ensuring a degree of fairness to the fiscal adjustment which will improve the chances of it being accepted by the nation.

It was pleasing the notice the stark difference in the treatment offered to M. Monti from Mr. Sarkozi and Ms. Merkel, as opposed to how the two of them made Berlusconi a laughingstock, only a few weeks ago. In yesterday’s three nation reunion, the continent’s top three economies made a show of unity, even as not much substance was disclosed.

The bottom line continues to be that, having been burnt by Greece and Italy already, Frankfurt and Berlin will only capitulate on the issues of QE and/or Eurobonds, at the very last minute. We have two observations/analogies to make.

The first one is that the European and world leaders are keenly aware that this train is headed towards a big wall, and they must deviate it pretty quickly, and that there are few alternative routes and not much time before the sheer speed will make it difficult to call if it is not too late to make the change.

The second is that we read yesterday that Germany has bought a first class ticket on the Titanic. This is an apt comparison. Germany is betting that by delaying to the last possible minute the inevitable decisions, it will ensure that the profligate southern Europeans will execute on their promises this time rather than just doing lip service. The problem is that with regards to Italy at least, even with Monti at the helm, Germany doesn’t trust parliament to vote for his measures, given that Berlusconi can ‘switch Monti off at any time,’ as someone attributed to Berlusconi.

Basically, we probably have good pilots driving our Formula One, but the terrain is wet, the track is tricky, and visibility is decreasing…Let’s hope that they know what they are doing.

After requesting, and obtaining, the heads of the three Prime Ministers of Greece, Italy, and Spain, the markets do not appear at all satisfied with the simple notion of change. As we discussed last week, the cure that would have done the trick a few months ago, is now treated as ‘probably too little, certainly very late.’

What is happening now is that the markets will continue to test the new weak link, with France in the sights of the markets because of the exposure of its banks, until, probably a minute before it is too late—if we are lucky—mighty Angela Merkel will save the day.

There are essentially three scenarios ahead of us. The best case scenario is that possibly through a joint intervention of the IMF (led by an experienced French lady…), Mario Draghi will get Merkel’s green light to effectively become the banker of last resort to the troubled European states. This may happen either, as we discussed previously, through a clear statement that the ECB will do all it takes to keep a lid of yields, just like the SNB has effectively done with the Swiss Franc, or via an intervention of the IMF co-financed or co sponsored by the ECB, or by Germany agreeing to the ‘euro-bond.’ It is unlikely at this late stage that anything other than clear, concerted action with the clear backing of Germany will work.

The second possible scenario entails the breakup of Germany, and possibly the other strong euro members, from the Euro. This would leave the euro as a weaker common currency shared by the eastern and club med countries of Europe.

The final scenario, probably the most disruptive, is a complete breakup of the euro, which could be triggered by Spain, Italy, or even France.

Both latter scenarios would be caused by Germany being too scared, for historical reasons, to take the political lead of the continent, which is what would effectively happen if it became the main lender of last resort, or the underwriter of the euro bonds. Leaders sometime have to take tough decisions, and Germany is too worried of the negative sentiment that could be engendered by it starting to effectively dominate the continent again, this time through its Teutonic credit rating, rather than by its military might.