The world’s oldest bank – Monte dei Paschi di Siena – failed the stress test of the ECB, and one day later also the test of the financial markets. On Monday, its listing had twice to be suspended when investors divested and brought the stock price down by 20%. Based on its balance sheet from December 31, 2013, Monte misses  €2.1 b. This figure may be outdated and the actual amount may be a bit smaller today. Given that Italy already stead that neither Monte nor the other failing banks can expect state injections they have to go back to financial markets to upgrade their equity capital.

The fact that overall nine Italian banks did not pass the stress test is disturbing but actually not very surprising. Italy is sitting in a no-growth trap since quite a while. Frankel (2014) pointed out that Italy would be since six years in recession if one would use the technical definition of recessions that is the standard of the Business Cycle Dating Committee of the NBER. Rather then using a fix rule of the thumb-procedure where a recession automatically requires two consecutive quarters of falling GDP, the Committee takes into account a broad spectrum of indicators and, most important, allows for quite some interpretation. In any case, Italy lost between 2007 and 2013 8.% of its GDP (Manasse 2013). It seems to be self-evident that a shrinking economy will not have a prospering financial sector. In this respect it is no surprise that close to 22% of all claims of Italian banks have been labeled as potentially defaulted. Italian banks have about €400 billion of Italian government bonds in their books, not least because they used the injections of the ECB to buy government bonds because they promise risk-free interest receipts – as long as the ECB can hold its promise to avoid any sovereign bankruptcy.

This game may continue for quite a while. Italian deflation, however, may cause problems. According to Istat, in September the annually-adjusted  inflation rate was -0.2% due to a further price fall of 0.4% compared  to August. Deflation is troublesome for an economy with high debt ratios, and this for a number of reasons. First, long-term investment is being postponed because future profits will be worth less then short-term investments. This is not helpful for efforts to improve capital and labor productivity. Second, shrinking price levels make consumers to delay purchasing larger items as they expect that those become cheaper in the future. Third, in a situation where3 central banks already reached the lower zero bound monetary policy-making is getting more difficult and the anchoring of positive inflation expectations is getting undermined. Fourth, the real debt burden is increasing, and this increase requires tough choices in a situation of stagnant or even shrinking budgets.

Let me add that deflation has not been part of the stress scenario of the ECB. This is a bit surprising because the Eurozone time ago has entered a deflationary zone, and it would have been wise to take this reality into account. In the Italian case, deflation means that the country will have more and more problems to come up with a positive primary balance. latter is part of the Fiscal Compact that has been signed off by Italy. Violating the SGP and missing out on the Fiscal Compact may become the new normal for Italy, and Renzi already expressed his disgust against the EU bureaucrats who are supervising the rules and obligations of the new fiscal reality of the EU. All this promises more struggles in Brussels at a time when financial markets start looking again more carefully on the Eurozone.