Macro and Markets

The post-referendum market response to Italy’s referendum mirrored the reaction following the Brexit and U.S. election votes: calm after a knee-jerk negative reaction.  After all, not much has changed—Prime Minister Renzi stays on in a caretaker role (perhaps through end year), after which it is expected a new government with similar political orientation would take over with a rather narrow mandate to pursue a revised constitutional reform plan, address critical governing issues such as migration, and complete a fix of the banks. Most market participants do not expect snap new elections. Italy today in this sense does not look much different than it did yesterday. The fact that tail risks have been avoided this time is heartening. It in part reflects confidence in the European Central Bank (ECB), which is expected to extend quantitative easing this week and could consider other measures (such as advancing purchases) to support Italian bonds should market spreads come under pressure.  Tail risks are by definition unlikely but dramatic if they occur, and sometimes they do. Like the Brexit rebound, today’s market calm doesn’t reduce my concern about the economic risks going forward. The central economic risks facing Italy today are the same as before—banks and growth. Efforts to recapitalize the Italian bank Monte dei Paschi di Siena (MPS) now look in danger of collapse, as heightened political uncertainty may undermine investor’s willingness to back a €5 billion bank recapitalization plan strongly supported by Prime Minister Renzi. If so, a defacto nationalization by the government is likely required.  MPS’s problems by themselves are not a systemic risk for Europe, but they are a bellwether for broader risks facing an undercapitalized and barely profitable Italian banking sector that, collectively, is systemic.  Under new European Union (EU) banking rules, Italian banks need to recapitalize by end year, and the risks of a broader shortfall are now significant (most importantly, if market turmoil undermines efforts by Unicredit, Italy’s largest bank, to complete its €13 billion capital raising effort).  Europe should consider extending that deadline, or otherwise creating additional leeway for state support, as a broader bail-in of private bank creditors, if required under the rules, would be destabilizing in the current unsettled environment. All this occurs against the backdrop of incomplete monetary and financial union. It is almost cliché to argue that the current state of economic and financial integration is unsustainable—Europe must move forward or back, but can’t stand still. For now, easy money from the ECB enforces a quiet stability, and bond spreads for Italian banks (and for the government as well) remain quite low, but they are vulnerable to spiking higher. Still, with the ECB buying program in place it may be news flow about recapitalization and stock prices, rather than government bond spreads, that could be the leading indicator of an emerging banking crisis. Banks without adequate capital don’t lend, and that means that perhaps the most significant legacy of the current vote is a continued headwind to anemic Italian growth.  Unemployment likely will remain sky high, and disaffection with the current mainstream (and pro-EU) policies is likely to remain similarly high. That means that Italy remains an economic risk—perhaps the most significant one—for the future of the euro and Europe.  There may also be broader spillover effects—notably in hardening views in Germany and other creditor countries towards debt relief and an International Monetary Fund deal for Greece—but the euro can survive Grexit.  Italy is another matter.

The election of Donald Trump creates extraordinary uncertainty about the future course of U.S. economic policy. Markets don’t like extreme unknowns, and there are valid reasons to fear that Trump’s policy proposals on trade and our economic alliances would be seriously disruptive to the global economy. Global stocks fell sharply when signs of a Trump victory emerged Tuesday, but by mid afternoon Wednesday U.S. stocks were up as markets found their footing on hopes of fiscal stimulus.  Meanwhile, U.S. Treasury yields were up and the Mexican peso weakened. It is reasonable to expect that substantial market volatility will be the norm in coming weeks. My colleague Ted Alden has written in depth about the policies of the new president in the areas of trade and immigration, and has a thoughtful piece today on the implications of Trump’s win for U.S. trade policy. My note looks at other elements of the economic agenda. President-elect Donald Trump seems set to pursue a dramatic, even radical, revamp of the U.S. economy. His advisors have signaled that, on assuming office, he will use executive orders in a wide range of areas including trade, immigration, and financial regulation. Beyond that, though, he will need congressional support. While he will have the advantage of Republican majorities in both houses, his economic policies are in many respects outside of traditional Republican orthodoxy, suggesting that he will need to build bipartisan coalitions on specific issues. His plans for an aggressive tax cut and advancing critical campaign promises—in areas such as infrastructure, repealing and replacing Obamacare, and energy reform, are likely to fall short of the 60 votes needed in the Senate to advance. The critical question will then be whether he seeks to build coalitions across party lines, at a time where there are limited areas of consensus. The short view--a worried market and a lame duck Even before President-elect Trump takes office, the election will guide progress on the economic agenda. The current and future president, and perhaps more importantly the Federal Reserve, will need to calm markets and signal confidence in the resilience of the U.S. economy. President-elect Trump also will need to walk back his suggestions during the campaign that he would renegotiate the debt or interfere with the independence of the Federal Reserve. Providing that reassurance will not be easy. As for fiscal policy, the lame duck session of Congress that begins on November 14th will need to, at a minimum, pass an appropriations package before the current funding bill expires on December 9th. This, along with the National Defense Appropriation Act (NDAA) and a water development bill that would include resources for Flint, Michigan and Hurricane Matthew relief, appear to be the only “must-pass” pieces of legislation in the session. While some elements of the President-elect’s economic agenda could be addressed as add-ons to these bills, the more likely scenario is that difficult decisions are left for the next Congress. Consequently, it appears increasingly likely that, as regards the economic agenda, the lame duck will indeed be lame. The long view--confrontation and gridlock Once in office, Trump has the executive power to pull out of trade agreements, restart the Keystone pipeline, and bring trade cases against China, all central promises made by Donald Trump on the campaign trail. Enacting core elements of his program beyond those initial actions, however, would require cooperation with Congress. What this means for fiscal policy is far from clear. Over the past year, with the economy on steady ground, and the Federal Reserve seemingly committed to a slow, steady normalization of interest rates, there was a reduced sense of urgency on the fiscal front. It is likely that, while we could now see some fiscal easing, particularly in the context of a FY18 budget that will see pressure to ease the sequester caps, for the most part it appears likely that congress will continue to demand that new spending initiatives be “paid-for” by new revenue or spending cuts elsewhere. The logic behind a grand bargain that would link comprehensive tax reform with efforts to put entitlements on a firmer long-term basis remains on the table, but the election campaign that concluded saw little support on either side on curtailing entitlement programs (beyond Republican calls to replace Obamacare). Repatriation is a mother lode of “pay-fors,” but pay for what? Short of a grand bargain, there does seem to be bipartisan interest in a deal that would allow for a repatriation of foreign income by U.S. companies (Donald Trump appeared to support such a deal during the campaign). By some reports, there are $2.5 trillion in profits parked offshore by U.S. companies, and a deal to bring that money back could raise as much as $200 billion in revenue. Much of the low-hanging fruit that could be used to pay for new programs has been harvested, and so the repatriation bill (that also shifted taxation to a hybrid territorial system) is critical not only as a matter of tax policy, but also for what else it makes possible. But then, if repatriation is on the agenda, what would it pay for? President elect Trump has articulated a wide set of economic issues on which he would like to move forward— At the top of the list would appear to be an effort to repair our aging infrastructure, on which there would appear to be bipartisan support. Large-scale tax cuts also will be on the agenda, but non-partisan analysis suggest that Trump’s plan would lead to massive increases in the deficit (unless Congress assumes unrealistically high growth rates). I expect, and hope, that Congress would balk at this plan. Even for a paired down set of cuts that also reformed corporate taxes, a repatriation deal would likely be needed as part of the package to compensate (at least partially) for revenue losses. And of course he would have strong Republican congressional support for a reform of Obamacare, which could also require pay-fors. Looking abroad, the economic agenda includes an array of international challenges. Brexit, growing pressures on the eurozone, and what to do about rising trade imbalances with China and other emerging markets, all are set to be challenges to the new administration. Policies attacking China for currency manipulation (at time that China is spending reserves to resist depreciation, the opposite of what the law seeks to prevent) are sure to provoke retaliation and disrupt growth and trade. Financial policies are also on the agenda. A deal raising the federal debt limit also will be needed next year. Separately, appointments for the administration on financial policy will be watched closely. Donald Trump has called for a revamp of the regulatory framework adopted after the great recession, but aside from a dislike of Dodd-Frank legislation it is not clear whether there is a consensus on how to proceed. The Federal Reserve also will be an issue, with a significant number of seats on the Board of Governors open (or likely to open) over the next year. In addition, the new administration is expected to move to appoint a financial vice chair and replace Janet Yellen in 2018, at a time of challenge to the Fed from both left and right. Finally, on the housing front, it is unlikely that we will see movement on the government sponsored enterprises (GSEs) and on the framework for supporting home ownership. The outlook for the economy may depend on whether the new president resists the temptation to overuse executive orders to force rapid and contentious changes to the U.S. economy, and instead looks to congress to build a strong governing relationships and a coalition for reform. In any scenario, we are taking U.S. economic policy in uncharted directions. The results are likely to be consequential for the economy for some time to come.