Quarterly Economic Outlook July 2019 - Highlights

World economy in a fragile position. For Italy stagnation is the most likely scenario

Prometeia's Quarterly Economic Outlook - March 2018 - Highlights

The world economy is growing at slightly above 3%, while Italy’s GDP should record a zero growth in the second quarter of 2019 and increase by 0.2% in the third and fourth quarters. In this context, the Italian government is gearing up for September when it will present its economic and financial plans for 2020.


Here are the main highlights included in the July 2019 Quarterly Economic Outlook:

  • Italy’s GDP growth +0.1% in 2019 and +0.5% in 2020. While the better-than-expected public finance trends have allowed avoiding the European infringement procedure so far, a turning point is to be expected in September with the presentation of the Update to the Economic and Financial Document (DEF) and later the 2020 Budget Law
  • Prometeia foresee the introduction of a "mini" flat tax and an extension of the Citizenship Income (Reddito di Cittadinanza) to include a wider number of beneficiaries. The latter represent additional expansionary measures to be covered by a revision of tax expenditures and an increase of reduced VAT rates
  • World economy growing at a slower pace: +3.1% in 2019 and 2.6% in 2020. There are three main risk factors: the trade tensions between the US and China, the slowdown of the US economy (+2.6% in 2019; +0.9% in 2020), the weakness of the euro area (+1.1% in 2019; +1% in 2020) 
  • The automotive sector continues to be one of the main factors slowing down the Eurozone
  • Given the weakened growth outlook, central banks are ready to step in, although they have limited room for maneuver. Prometeia expects rate cuts of 25 basis points by the Fed after the summer and of a cut of 10 basis points on deposit rates by the ECB before the new series of Tltro will be launched in September.
  • According to Prometeia, there is a lack of a safe asset at the European level, defined as a risk-free asset shared by Eurozone Member States, which could contribute to increase financial integration and support the euro as a global currency

Italy and the challenge of September

The better-than-expected public finance trends, as indicated by the 2019 budget updates, and the 2019 target deficit below 2.1%, allowed the government to avoid the European infringement procedure. However, any agreement with the European Commission will have to include a 2020 budget balance in line with that of 2019, which will inevitably lead to an increase in revenues.

On the expenditure side, Prometeia hypothesizes – within an appropriate reform of the tax system - the introduction of a "mini" flat tax, targeted to a narrower number of households than that proposed so far by the government, and the strengthening of the Citizenship Income (Reddito di Cittadinanza) to compensate for the lower effectiveness of its current design. Prometeia simulates a 15% flat tax scheme applied to household incomes below €29,000. The number of individual beneficiaries would be 3.6 million and the scheme would have a cost of €4.1 billion. Also, Prometeia hypothesizes an extension of the Citizenship Income (Reddito di Cittadinanza) to include a wider audience of recipients, by increasing the income threshold to €10,800 per year. By doing so, the measure would target 400,000 more families (1.7 million total), for an additional expenditure of €3.1 billion.

On the revenue side, avoiding an increase of the VAT rates will be difficult. Prometeia hypothesizes an increase of the reduced VAT rates, namely from 4% to 6% and from 10% to 12%, equivalent to about €6 billion of additional revenue. Moreover, it hypothesizes an expenditure revision of about €3.3 billion, as well as a tax expenditure reform. Against this background, without sound measures to support potential growth, after the 2019 stagnation (+0.1%), the expected recovery in 2020 (+0.5%) and 2021 (+0.7%) will not be sufficient to reduce public debt.


The world economy grows, but only on thin ice

Global growth continues, but three main risks are making the outlook even more uncertain than in previous forecasts. This uncertainty could break the fragile balance between the high prices of financial assets and the high levels of indebtedness.

With regards to tariffs (first risk factor), the "short term pain for long term gain" strategy of the US administration is still limited to the first part of the motto. Overall, the lower imports from China have so far only been partially substituted by those from other countries, primarily Asian countries. In the absence of a complete replacement of imports from tariff-exempt countries or increases in domestic production, tariffs are causing a surge in US firms’ costs. These costs will be passed on to the prices of final goods, to the detriment of consumers, or absorbed with a reduction in profit margin, which will further slowdown corporate investments. A potential drop in aggregate demand linked to a further worsening of growth expectations (second risk factor) could accelerate a slowdown of the US economy.

On the European front, a stronger than expected slowdown of the German economy (third risk factor), linked to the impact of the hard Brexit - at this point the most likely scenario - and to the potential introduction of tariffs by the Trump administration on the automotive sector. The automotive industry, which in Germany accounts for 20% of manufacturing value added, has already suffered from the implementation of new regulation on carbon emissions and from its decline after years of expansion. Electric cars, driverless cars and car sharing are structural changes that are transforming the future of the sector, forcing car manufacturers to make significant investments to adapt to the changes, in a context of weak overall demand.

Against the downward revision of growth expectations, central banks have revised in recent months their forward guidance. But their room for maneuver is limited: part of the weakness characterizing inflation is structural and could hardly benefit from a further expansionary monetary policy. Central banks are in a complicated situation: further expansionary measures could have limited effects while at the same time jeopardize their credibility.


Why we need a European Safe Asset

The economic and financial crisis has increased the demand for safe government bonds (Prometeia Discussion Note July 2019). However, between 2012 and 2018, the amount of these bonds has decreased over time. Unlike total debt, which has increased. Excessive demand for safe bonds has led to an increase in their prices pushing down their returns. While lower-rated government bonds had to pay a higher interest rate. This phenomenon exacerbates during periods of stress, causing financial fragmentation. According to Prometeia, a safe asset shared at eurozone level would contribute to limit this problem supporting the euro as a global currency and fostering the diversification of banks' sovereign portfolio, enhancing the stability of the area. The debate has been ongoing for quite some time, but there is a lack of political support. There are two ways to proceed. The most comprehensive is the issue of a safe asset by a euro area fiscal authority, but this option is politically difficult to pursue, as it would entail mutualization of risks. Another option is for the market to issue a safe asset: the safe asset would consist of the senior tranche of a pool of euro area sovereign bonds. Such a scheme would not involve any risk sharing.