Turin, october 2016

Mario, the giver of alms

We’ve taken some time to delve into the courtesy visit by Mario Draghi to the German Parliament, to see if there were some interesting tidbits coming out. Lo and behold, there has been an outstanding one.

First off tough, we have to put out a disclaimer. Try as we might to adhere to the pravailing view, we’re still not convinced that the battle cry “deflation is bad” holds any water in reality, and that leads us to believe that either the ECB is on a fool’s errand, or there are ulterior motives.

Which leads us to the widely reported assertion which was at the center of press reporting:

In his speech, Mr. Draghi said the ECB had made the [mr. Schauble’s] finance minister’s job easier. “The low financing costs for government bonds help to balance the budget and reduce debt at a considerable speed,” he said.

And, there lies the rub, because he is widely reported to have added:

“Draghi rebuffed lawmakers’ criticism, arguing that the German government alone had saved 28 billion euros last year through lower than expected interest payments.”

Now, I cannot claim a perfect knowledge of the financial world, or the intricacies of the public sector accounting standard, but I think I am a fair hand at dissecting where the money goes and where it comes from, so let me test your patience by indulging in this thought experiment.

Imagine that you are a public servant, whose responsibility and duty of care is to report, as accurately as possible, how much tax the private sector pays. Imagine also that your scope is as broad as possible, it’s not a mere elencation of taxes incurred and bank movements; It’s a true “wise man’s” assessment of the impacts that policies have on the economic life of the average taxpayer.

So, what’s your reaction to Mr. Draghi’s rather brusque wording? Let’s find out.

Assuming that his claim is valid (i.e., that there is a causal relationship between the OMT government bond buying program and the compression of market yields witnessed in European government bonds), national accounts as reported can be recompiled. Namely, in the case of Germany, the line of reasoning is this:

Given the size of the German economy, Draghi’s intervention is the equivalent of a tax on interest income coming in at roughly 2,5% of GDP per year. Congratulation, all concerned!

Just to clarify, it’s really a moot point for us the difference for a financial investor between receiving an interest income of 2% taxed at 100%, and receiving 0%. As a voter I might wonder just who gave a sovranational entity that kind of authority, but I digress.

And my beloved country, Italy? Ah, that’s a wholly different kettle. In size terms, at least.

To further limit our tendency to speak ill to power, we’ve taken as a starting date the “whatever it takes” declaration, since that’s the day Mr. Draghi managed to quell the disturbance in the force. You can see from the chart that’s not the most extreme data point.


Source: Bloomberg

Since then, Government rates on an intermediate BTP have fallen by slightly less than 5%. To be fair, that does not imply that the average cost of government debt has fallen as much, since there’s no practical way to renew all the debt issued all at once. But just as a thought experiment, let’s do some math.

Let’s take a smaller number, just to make sure any German reader does not have an heart attack, and say that the impact in terms of yield has been 3,5%. Multiplied by the Italian government debt, about 2.25 trillion, it comes out to about 80 Bn. Euros, which as expected is more than twice the amount “saved” by the German government. BUT, how much was the impact in terms of “increased taxation”?

Financial assets held by Italians have been estimated at 3.500 bn. EUR; if we guesstimate the exposure to interest bearing assets at 3.000 Bn., the negative impact of the ECB on interest income comes out at about 100 bn, or about 6% of GDP per year. Incidentally, this ratio is similar to the original Amato maneuver that Italians still remember with a mix of dread and fear. remember that the government includes non-tax-paying GDP in his estimates of fiscal pressure, so the weight of the yoke on legitimate private business enterprises is understated by about 10% of GDP anyway.

This is particularly relevant today, when

“[…] Two senior ECB officials warned early this week that subzero rates could, over time, cause banks to reduce lending to the economy – the opposite of what the central bank hopes to achieve.

Before somebody jumps up to say ”Gee, who would have thunk it?”, let’s see the math of it. And remember, should it all end in tears the verry flower of Economic academia will swear to all and sundry that it was not possible to predict the outcome.

Let’s  have a go at an example again. Imagine you are the owner of a Casino in Vegas, which you paid the licence on, and that the only game the gambling authority allows is roulette. After a while, a brilliant functionary of the Gambling authority comes with an edict, changing the working of the roulette wheel: “henceforth, the wheel will still have one zero, but the numbers will go from 36 to 3600, and the bet on a single number will pay 3599”.

The wise man would not be surprised of the casino owner announced a wave of layoffs immediately. His take has just gone from 2,7% to 0,0278%, so he can expect his revenues to go down exponentially. That’s our view on the logic of cutting rates in the banking system: it totally discourages the operators (banks) to play in the market.

This could be construed to mean that the official ECB policy of buying government yield into the ground has some unintended side effects and it might be reversed in the future, consult your physician in case of further side effects. BUT, if and when this policy will be reversed, would Mr. Draghi be equally candid and assume responsibility for the drain of government money?

Who knows, next year’s headlines might be: “Mario Draghi claims responsibility for putting 28 bn EUR in German savers’ pockets”.

[1] As calculated by dividing 28 Bn. By the average federal government debt 2008-2015. as a further check, we used the 6 year constant maturity rate, which gives a rate fall of 3,7%.

This article represents the writer’s view. In no way it can be construed as a recommendation to either sell, buy, or get involved in any security investment.

Giovanni Ponzetto

Giovanni Ponzetto

Socio in Tokos
Si occupa dal 1988 di investimenti finanziari.
Ha lavorato come gestore per primari gruppi finanziari e assicurativi.
Giovanni Ponzetto

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