I love Lars Christensen’s work. Simple but elegant. This is a bit wonkish for an investment blog but he makes a very important point which applies to far more than just Italy.
Today I was interviewed by a Danish journalist about the Italian banking crisis….. He asked me a very good question that I think is highly relevant for understanding not only the Italian banking crisis, but the Great Recession in general.
The question was: “Lars, why is there an Italian banking crisis – after all they did NOT have a property markets bubble?”
That – my regular readers will realise – made me very happy because I could answer that the crisis had little to do with what happened before 2008 and rather was about monetary policy failure and in the case of the euro zone also why it is not an optimal currency area.
Said, in another way I repeated my view that the Italian banking crisis essentially is a consequence of too weak nominal GDP growth in Italy. As a consequence of Italy’s structural problems the country should have a significantly weaker “lira”, but given the fact that Italy is in the euro area the country instead gets far too tight monetary conditions and consequently since 2008 nominal GDP has fallen massively below the pre-crisis trend.
That is the cause of the sharp rise in non-performing loans and bad debt since 2008. The graph below clearly illustrates that.
I think it is pretty clear that had nominal GDP growth not fallen this sharply since 2008 then we wouldn’t be talking about an Italian banking crisis today. There was no Italian “bubble” prior to 2008 and there are no signs that Italian banks have been particularly irresponsible, but even the most conservative banks will get into trouble when nominal GDP drops 25% below the pre-crisis trend.
Market monetarists advocate that central banks should maintain smooth monetary growth consistent with a nominal GDP target. Current central bank response is lagged because they have to wait for inflation and employment numbers — which is about as effective as driving your car down the highway while looking in the rear view mirror to see where you are headed. Even then, they focus on the wrong numbers, inflation and employment, when the root cause is monetary growth and nominal GDP.