Hamish McRae: Why the market has moved against Italy

Economic Studies

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Italian debt is downgraded and European shares climb. So that must be good news, eh? Or maybe not. Sometimes the twists and turns of the financial markets are indeed puzzling to outsiders: why on earth, given their spectacular errors of the recent past, should the rating agencies and the bond markets have become so important?

The relatively sanguine reception to the downgrade is easy to explain: the news was expected – the downgrade was, so to speak, "in the market". The harder thing to get one's head around is the continuing respect in which the rating agencies are held. The best explanation of both this new austerity in financial markets and of the significance of the Italian downgrade is that debt levels that are acceptable in times of confidence are not acceptable in times of fearfulness. That goes for individuals, for companies and, as we can now see, for some governments. The rating agencies and bond markets are mirrors of us. They now reflect people's current fears, whereas four or more years ago they reflected their hopes.

So the downgrade is merely telling everyone what they already knew: that Italian public debt, at nearly 120 per cent of GDP, is unsustainable given the country's shrinking workforce and rising burden of retired people. But during the boom, people accepted this because the debt levels had been high for a long time and the country had managed to cope with them adequately. The bottle appeared half-full, rather than half-empty.

Another example of the way in which the mood of the markets has shifted was brought home to me when I was told by a corporate treasurer that they had stopped placing any money in Spanish or French banks. That may seem an extreme reaction but if you have the responsibility for placing other people's money, it makes sense not to take any risks, however limited, that you can avoid.

The same mood applies to professional fund managers in the bond markets. You may think that the risks of lending 10-year money to Italy are small, but they are not negligible. You won't get sacked for holding 10-year German debt; indeed if you bought it five years ago you should be promoted. You might be sacked for having bought 10-year Italian debt. And you deserve to be if you had bought 10-year Greek debt.

Such mood swings are extreme and by their very nature do not last for very long. But until there is some resolution of Greece's situation it is hard to see the mood swinging back. Paradoxically a Greek default, with investors getting perhaps half their money back, might boost confidence rather than erode it. Lenders would at least know where they stood, and if that meant that some European banks had lost so much money that they had to be recapitalised, so be it.

Meanwhile, reflect on this. Maybe the euphoria that four or five years ago surrounded the euro in particular and financial markets in general was an aberration. What is now happening – real and continuing fiscal discipline being imposed on borrowers by financial markets – is more normal, the new normal in fact.

Indeed if you go back to the second half of the 19th century, even a country as wealthy as Britain, the anchor of the gold standard, had to pay great attention to funding its national debt, with the normal pattern of paying down debt in peacetime and only increasing borrowing to pay for wars. In a sense, the euro is imposing a similar discipline on Europe as the gold standard imposed on Britain a century and a half ago.

And so remember that countries can turn themselves round. I recall talking with a white-faced permanent secretary at the Treasury in 1976, just after the Government had applied to the IMF for an emergency loan. "We've nowhere else to go," he said. "We have only a few weeks of reserves left to pay for our imports. We have to get that loan." Well, things did turn round for us. They will for Italy ... but maybe not just yet.

A mansion tax won't raise big money

How do you make the rich pay their share? It is a theme, of course, of the Liberal Democrats' conference but one that is echoed not just around Europe but across the Atlantic too. President Obama's new plan to narrow the US deficit increases taxes on the American wealthy. It is an issue about which people on both sides of the debate hold very strong views so perhaps the most helpful thing to focus on is the practicality of rebalancing taxation so that it is easier to raise money from the rich.

The Lib Dem notion that you should tax property rather than income (ie. replace the 50 per cent top tax rate with a mansion tax) is interesting because you cannot move property whereas many people can move income, or simply tax less of it. Greece is trying to block holes in its leaky tax collecting system by imposing a property tax that will be collected via houses' electricity bills.

The trouble with taxing property is that it is hard to raise big money that way. There are only a limited number of top-end homes. If you push the tax net further down the scale there is a danger that you will force people to abandon larger homes and split them into flats, as happened to large swathes of British housing stock after the two world wars. You also discourage home improvement and you may well depress home prices. So you can increase taxes on property, but to do so will have side-effects and not necessarily predictable or beneficial ones. The basic rule with taxation is the simpler the tax, the cheaper it is to administer and the harder it is to avoid. But that is not the direction that we, or other western democracies, seem to be going.