Euro Isn't a Well-Designed System, Zingales Says

Bloomberg dot Com, and of course, on the Bloomberg. Yeah. So, days after the anti establishment five Star Movement and the anti immigrant League walked away from a bid to form a coalition Italian government, according to a senior state official, the president of Italy wants to find out whether they're ready to revive it. Joining us now, I'm ready pleased to say is Luigis and Galas Chicago, both school finance professor, and he joined us on the phone, Professors and Galas.

It was started by a president who gave legitimacy to an I here that wasn't clearly on the agenda at the time. It's a curious event that's taking place in Italy. Luigi, yes, it is. I think that I agree with you. That was the president that spook the market more than the populace. That the fact that he raised the issue of you will exit and made us think out of not appointed. Somebody has announcements to really created a lot of uncertainty. I don't know what is going to have to really,

the situation is very much in flux now. So, Professor, the key question I think for markets that everyone should be looking out for is whether we get a new election one and two, what kind of platform did these two parties run on in that election? Is it clear to you, Luigi, that if we had another election in Italy that those two parties would run on a platform to leave the Eurozone. No, I don't think that they

will run on that platform. I think would be suicidal honestly to a campaign on that front, because people were started running to get their money out of the bank as the ballots accounted. So I don't think they will do it. I think that the the Democratic Party will try to train them to run a campaign the direction, because it is in his interest to do that. But I don't think this will happen. So for anyone worrying, Professor about an existential crisis in Europe, once again, what's

your message to them at this point? So? I think that we're always in theistential crisis. I think that the problems of Italy indicate that the you is not a well designed system. And I think that everybody knows it, but nobody has the card to say. It is a bit like the Emperor's no close and we need to fix it. The question is is their willingness to fix it?

And if they is not willing to fix it? Uh was stun who used to say, is something is not sustainable, eventually will not su state And I'm stating the obvious. But eventually we're obviously state. Whether it is because of the fight that movement, or because of this or because of that, that's that's sort of accident. The substance is we need to fix it, right, Luigi, wonderful to have you on in this time of turmoil in Italy. And it ar cons back to what was the book of

the summer for me. I recall a number of years ago, your wonderful book on American capitalism. Describe European capitalism right now? Help our European listeners with what capitalism is in Europe. I really can't figure out a good definition. Actually is very different across countries, and I would say that it is one in this moment. One advantage of the U over the United States is that they seem to enforce

the rule of competition better than the United States. The anti trust is more aggressive and is less easy to buy out the legislator. At the European level, I think it's just a transitional phase and eventually things will converge in the war state. But at the moment, I think this is in advantage with the United States. I mean with within it is. I guess where GDP is in the whole disappointment here has been where GDP has been in the United States for X number of years, and

for Europe and and all that as well. A little bit of inflation today reported in Europe. Are you optimistic that we will see a power like inflation lift in America? I think that my reading of the data is that the lack of inflation is due to the lack of increasing wages. And ironically, maybe we've gone too much the other ways. There was a huge pressure to reduced wage,

reduced the power of label. We do s this will use that eventually, maybe we over shot and and we need to give a little bit more of arguing power to h to label so that wages will go up. And when wage you will go up in station, we go up as well. The professor, Before we lose you.

I think what's already stood out to a lot of market participants this week is how quickly liquidity evaporated in some of the world's largest markets, which we would expect to have liquidity at times of stress, and it just was not there. The Italian bond market is one of the largest bond markets on the planet, and what clearly happened this week was a move sparked by politics, but

amplified by the complete evaporation of liquidity. How concerning is that for you, professor, and what's the lesson that we can learn from this week? It is definitely concerning. It reminds me of the temper tantrum that took place a few years back, when the night just started to announce

that you will start increasing rage. I think that what happened, in my view, is that a lot of people were long on Italian bombs, not because they believed in Italy, just because was the highest security around and as a result, we're ready to rush to the door for the first

at the first sign of problems. So I think that we have seen the effects of this reaching for il which is as we know, tend to be the stabilizing and I think to some extent this book has been useful because as all people, that is not a one way back and they can actually lose money, and so I'm sure that they're going to be more careful in the future. Luigi, one final question, if we could have you made plans to attend the World Cup this summer?

One World Cup this year? Don't you know that, professor? Professor, there is a more important question for you. Would you accept the positioners finance minister in Italy? It was that would be a more important question. Nobody has offered it to be, so you can give me a shoa that

I would be watching their the world happen well. But within this Luigi to Mr Farrow's important question, Carlo Cardarelli has been a wonderful and sustained guest on Bloomberg Surveillance over the years with his fiscal work and original work at the International Monetary Fund. To see Mr Cardarelli and Zingalis in tandem in Italy, would I would suggest lift the spirit of markets? Is that politically feasible in your Italy to have academics associated with this phrase technocrats really

run the show? Is that feasible? So first of all, I don't think that being on Bloomberg is necessarily the stat to go to become minister. That's Joli, a prerequisite, Luigi, you, I'm sure, but the reality is actively I respect uh calibery badge. We have different views on many things, so I don't think that all technicals think to stay the same. And I think that it is important in my view to feel the pain that is around in Italy. And

I think people underestimate how devastated the country is. Twenty years of no growth in a cap almost fifty of youth and employment. I think that this is that this is a country that has lost hope and forget the World Cup. I think that people are not even dataset about that because there are much bigger problems around. And I think that whether you're a technocrat or not, I think that what people want is somebody ruling them that feel that pain. Professor sing Goes, thank you so much

for those important comments, particularly on your Italy. We greatly appreciate his attendance. He is Uh, of course with the Booth School, University of Chicago as well. Luigi as in, this is without question our interview of the day and is without question timely as we may see further tariffs today from the White House. Donald stras, I'm essentially invented China market economics, darkening the door of Mary lynch warton economics and others over the years, including the Milk and Institute.

He is with Mr Hyman over at Evercore I s I and continues a true focus on China. Who was the first premier or president of China that you dealt with professionally? You don't go back to mount right. No, John Zaman, who was uh in the nineties. Uh, he was. He was a smart guy, UM focused um any consensus builder. Now we are back to Chairman Mao days. Uh political strong man rule under Jin Ping. Uh. It's not uh,

not my idea of a good time. Can you explain to me how Mr g reacts to the bipolar advice that Mr Trump is getting, maybe personified by one view of free trader Lawrence Cudlow and another by Navarro singularly saying China is not evil but unfair in their trade. Uh. He listens uh politely. He and his team Uh Wangchi Shan who's a vice president, and Liu Hu who was a guy at DAVA and is in charge of the U S. John economic and financial relationship. Um, they listen politely,

but they don't react to tweets. They don't react to speeches too, reports. They react to actions. So wait until you see Washington do something. Then you react, but not before, don't. I read this term in the last twenty four hours, and I think it was in the Li Times. It was microwave diplomacy. I think it's a fantastic term. Microwave diplomacy short quick. You know, we used to diplomacy happening over time, over years of a decade, with with goals

of a long time horizons. This is very fast high heat. Does microwave diplomacy worked on I doubt it. I mean I I heat up my uh my cold coffee and a microwave now, and I guess twenty years ago, if I did it in a regular avenue would have taken a lot longer. I suppose it still works. Okay, but uh, I think, uh China, it looks at washing and I think, and they see, um, they don't see policy, they see results.

They see flip flop. They don't know what way to move, and so accordingly they were wait until Washington does something and then they react. Is it good? To keep China on the back foot, and he's China on the back foot right now. I don't think China is on the back foot right now. Uh. Some people have said that Washington. I've said that China. See is Washington is unreliable and uh unpredictable, and I think it means unreliable and untrustworthy. Uh. This last week, Um, we said we the US said

we're go. We will impose the fifty billion dollars worth of tariffs. Will not. Maybe that's drawing a line in the sand and maybe being unpredictable as a point guard is okay to go either way, but not in international relationships. Done the difference here? And John, I just I just did this in real time, Folks. When I say go to China, it's a bunch of Bologney. I get on a plane, I get in a car and go to

some fancy hotel. I'm within a football field of the hotel, a soccer field, John, and then I get back in the fancy car and come home. This time I actually went into China, but I didn't go to cheng Do. How is all this playing across all of industrial China, not in Beijing, not in Shanghai not in a long called how's it playing every place else? Well, companies throughout China who are involved in international trade and and all are in one way or another UM are perplexed. They

don't know what to do. Uh, there's this great deal of uncertainty because their biggest trading partner in the world is on an an uncertain path. Uh. So what do you do when you're uncertain? You run in place. You don't make long term commitments because you don't know whether the step that you take is going to ultimately be a step forward or back within This is the American feeling. A lot of our listeners are saying, right, John, you've been I give John for a huge credit for articulating

the frustration over there taking of our technology. Liz Economy really features us in her book The Third Revolution of how they're appropriating our technology? How do you respond to that? Are they? Are they bad guys that we can't play there unless we give them patent and copyright. I think China has been a serial um uh intellectual property, a thief, probably the biggest in the world, the best in the world for a long time. I don't think that's likely to change. Excuse me, we're it can be a hat

trick off. Okay, there you go. Uh, that's not gonna change in any material way. I think the forced technology transfer as a completely non Uh, that's a non item. No company is worse to operate in China, but if they do, they have to follow China's rules. No companies, Chinese companies are not forced to operate in the US. If they do, they're going to follow the US rules. I think that's a non item. Uh. And three oh one tariffs are not going to help this. They are

a step back. They are a lose lose, not a win lose or a lose win or a win win. They are a lose lose lose loses the red both sides. They're not forced to operate there though done. But the problem arises when the barriers to entry for Chinese companies in the United States are much lower than the barriers to entry for the United States into China. And I think it makes sense that we have an administration in the United States that tries to level the playing field.

That makes sense. Surely, sure isn't that what they're trying to do. I think that is what they are that they're trying to do. We'll see how successful they are at it. China is has a very different UH strategy

that state cap realism. Unlike ours, it has its pluses and within this UH done stress, I mean, if you're just joining us with a S. Donald Within this is the labor arbitrage that Steve Roach has talked about it years at Morgan Stanley and Yale, which is that marginal labor dollar in China migrating to Vietnam, migrating to other Asian geographies maybe Malaysia is one example. Give us an

update on how China competes in a more advanced labor wage. Well, the uh this is exactly what is happening is but this is not not new. Is the the medium scale manufacturing jobs, the low scale manufacturing jobs are migrating, have migrated to the lower wage economies that will continue on from Vietnam to Africa and so forth. At the high end, our my own view is our USK through twelve education system is completely broken. China's is the best in the world.

And what China has more than anything else is human capital that is of great value and importance. Alway goes a minute a half lift, Have done stress, I might want to talk about pollution. Can a totalitarian structure find the incentives to diminish air and water pollution? Or is that really want? An open capitalistic system is good at um Either side can do that. China, I think does not use the pricing UH tool well as they could on environment the force tool. Can they force? Sure? They

can um uh And they are doing that. And I will tell you that I think the most important economic dynamic in China for the next twenty years is environmental preservation and remediation. They know they have to clean it up. They have to do that for their own self preservation. Is the leadership at the margin? Is it finally getting better air quality? In UH? Fifty cities in China? Biggest ones are down air quality. The air quality index is down from five years ago. It's still bad, but it's

much better than it was. We continue to improve. Don stress, I'm thinking so much with the evercres I s I on China, Gino Martin Adams, with them, We're gonna really dig down here now into much more technical discussion of the equity markets. We do this for the cf A crew staggering late June UH and you know, see if a one, two, three, four, five, six. Where in the accounting statement is the dynamics that interest you the most

in American corporations. I think it's a really good question, because what we've seen over the last several years is actually a migration of investor attention up the income statement toward the balance sheet. Right, so investors are actually paying for sales beats and uh discouraging sales misses more so than they're paying for earning speats and discouraging earnings misses in stock price reactions. We also see over the longer term,

companies that are reporting consistent and robust sales growth. So companies with five year average sales growth that exceeds the market are outperforming companies with five year slower sales growth, and we're not seeing that extreme distinction on the part of earnings. You see it with cash flow as well, So cash flow like sales towards the top the upper end of the income statement, definitely providing performance. And then I also think the other thing to talk about is

the balance sheet. When we've seen over the last year, in particular, is investors paying up for companies with lower debt or lower leverage ratios and certain punishing companies that have utilized debt to a large degree, to the extent that their debt to EBITDA is above average, and especially the companies with debt to EBITDA ratios well above average have actually underperformed substantially. From where you sit, the synthesis of all Bloomberg intelligence, what is the dynamic if yields

lift to that debt burden. It's not linear, it's it is anywhere near where it is an inertial force. It really causes angst, not yet, because a lot of the debt is actually secured at long term low interest rates that do not reset. So that the positive aspect of this exactly so, even though rates are going higher, the companies are not experiencing a tremendous amount of pressure on their current debt. They can certainly sustain payments on that

debt with earnings accelerating. The problem becomes later in the cycle if rates reset higher on a more permanent basis, say five years from now, when companies go back to tap the debt market, they're going to have to pay a lot more for new debt. They're gonna have to pay a lot more for that maturing debt to refinance the debt. The other thing that I think is really interesting is in the tax package that was passed in December. There's inherently a component of it that disincentivizes debt use.

Because companies have been able to write off their interest expense UM when it comes to their tax bills for several years now, there's been a tremendous incentive to utilize debt, which explains partially at least why debt has grown as

much as it has. As part of the tax component or a tax package, this year, they will only be able to write off, of UM that interest expense to the extent that that interest expenses percentage of underlying earnings, and going forward that will be the percentage that they can write off will become less and less over time. Yeah, so we're starting to disincentivize debt, which you know depends

on if this tax reform becomes permanent. Right It's it's there's a lot that can happen in the next several years. But I think as rates rise, if we are going to continue to disincentivize debt, that could very much change the funding structure of companies as well. Something to look out for in the longer term, where is the tax dividend going the tax dividends, so that the extra cash, Yeah, it's for the most part so far going towards capital

spending plans. Right, I wouldn't go so far as to say that we've actually deployed a lot of that extra cash or the savings from tax. Initially, companies suggested that they were going to pay it out in the form of wage increases, bonuses, one time bonuses to employees. And through the course of the first quarter earning season, which we just completed, what we found is companies starting to announce capital spending plans. In Mass we saw the capital

spending the next twelve months. Capital spending growth is now expected to accelerate eighteen percent, for example, and we've been running at a pace below ten percent for the last year or so. So there is an evolution of um potential capex growth playing out through the earning stream. The company announcements. There's a little bit of buyback growth, so they are starting to deploy it back to shareholders, though I'd say that it's pretty slow in coming and it's

very narrow, not that many companies are announcing it. Though we are seeing buy back growth accelerate, and some companies, such as energy companies for example, have really been ahead of this. They've started to deploy capital in the form of buybacks and dividends where they hadn't in past years. So this sounds positive on the debt side because there might be less issuance on the equity side because it

should lengthen the cycle. Um if we do get this camp X story and supply side response when you have a fragile story internationally in a m now increasingly so in Europe too, do we see a buy America theme come back into this market in a way that we had things in say the back end early seven seen. Oh it's interesting because we have actually seen that the

small cap stocks have outperformed tremendously. When we talk about large cap stocks have sort of been stuck in this malaise for the last two weeks, just stuck at their Hunter day moving every ridge relatively volatile on recent news. But small caps are making new highs. Microcap stocks are making new highs. So the companies that are more domestically focused, the companies that benefit when the dollar rallies that are

more sheltered from international risks are absolutely doing better. It's that also going to mean a switch from from growth to value as well, given that those growth names are international by by definition on the spire, So normally it

would and it really intriguingly has not yet. So you would think that the recovery and small caps, the recovery and dollar focused companies, the recovery and the domestic names would start to produce a shift in value stocks in the SMP five hundred, and we have not seen that in mass yet. As a matter of fact, that financials in the SMP five have been one center of extraordinary weakness in this environment. It's a it's a big conuntry circle back to the income statement. Is that I mean

Charles Peabody is been brilliant on this portalent. Pebody was bullish, bullersh look like a genius. He flips to more negative. Now he looks like a genius. And is it because of a real question or revenue shortfall? I think it is for the top line companies, that's at least part of it. But the financials and the small caps are doing very well. So what I think is happening is the small cap financials are doing well because they're perceived

to benefit from deregulation and wave. They're also still lending and lending to lower credit quality borrowers where the large camps have been extraordinarily conservative and they're exposed to more, they're supposed to the international story, and they're not producing that extraordinary top line. One minute left with all of your experience at Wells fargoing now at Bloomberg is simply what is the pixie dust of Amazon? Where they're valued

not on profits? Where did that come from? Well, I think it comes from a desire for long term secular growth. So there industry cap there, there is a belief that a certain subset of companies are going to produce long term secular growth prospects that don't exist elsewhere in the index, elsewhere in the economy, and those companies are largely concentrated in the Internet space is a big theme. Amazon is

one of them, Facebook is another. Twitter as another. Right, So you've got this whole subset of companies that has this investor following because of their long term outlook, which doesn't exist in a lot of places. We've got to have you back before the CFA exams. We're gonna do five ratio DuPont and analysis of Gina Martin Adams here in about ten days, you can I have to explain what BTPs and you get to say that. I think that's a good point. I think I think I've been

checked there. We call that shade. Yeah, that was like the Big Chefs five ratio shade right there, Gina Martin Adams ahead of all of equities. Boomberg Intelligence thrilled. Ever, Deutsche Bank cannot find a bit. It's as simple as that. Four days ago we're down a good ten percent, almost eleven percent on a euro basis, we are a ten and change down to about with the news the ft article that we have. Deutsche Bank is a problem bank. We've moved and we're now trying to find a bit

at nine on Deutsche Bank. Catherine Man with us right now. We're going to continue with this discussion even as we want to talk banking. Of course, doctor Man cannot speak to us about UH financials and banks in particular. But there's too much else to talk to Kathy Man about at this moment um. I have to rip up the script, doctor Man and go back to your iconic book. Is the Trade deficit Sustainable? Mr? Trump, believes it is sustainable in this moment where we may seem new in complex

tariffs across different nations. From the White House, if Donald Trump was to read your classic, small book, easily digestible and three plane trips, what would he learn? What does he need to learn from your classic? Is a trade deficit sustainable? So I think it needs to learn that. Um, there are two sides of the trade deficit. One is, of course the goods and services, but the other side is capital flows. UM. And the two sides of the

same coin. And if you try to squeeze one side through protectionist measures, you have to be concerned about what signal that sends to financial markets about the welcoming nature of business in the United States. Uh. So, I think that that's the important ingredient, because you can't be protectionist on the side of trade and at the same time welcome international capital flows. So the surprise then could be dollar dynamics. Is that where we observe his strategy. Let

you see it with a strong dollar that surprises all. Well, I think that the strong dollar or the dollar dynamics are are driven by a whole lot of things. UM. Relatively stronger US economy, right now because of the degree of fiscal stimulus, no question about that, particularly visa the Europe,

which is going through a number of issues. Uh. And when we think about the consequences for protectionism, UH, you know, there's a there's a lot of rhetoric out there that UM is perhaps actually going to be backed up by by changes in policy on the steel side, with the new rhetoric on two three two with cars. You know, you've got the issues with Iran UM and so all of that is uh tempering the growth in Europe more than it is helping the growth in the United States.

Doctor man, time for one more question before we go to this important financial story away from your good word a good city group and and and that is the idea that maybe we've seen coordinated growth, combined growth ebbing. Do you observe that across your global mandate. Well, we've got it. We've got we've got the synchronized growth rate of the last two years continuing for this year. Uh, it could continue for next year. But there there are

cracks in that synchronicity. UM. And that you know is coming from the trade rhetoric, and that possibly the trade war, but it is also coming from um financial market turbulence that is part of the normalization of monetary policy, and that has you know, we have to have the normalization of monetary policy. UH. It's been a very long time with very money and so that financial market turbulence and how it translates into the real economy is something that

is going to be differential acrost countries. Dr Man, thank you so much, Katherine Man, and we're too rude with her today ahead of all of global economics for City Group, as we have to move on to breaking UH news. In course Kathy Man and there mentions the idea of turbulence, it is a good time to turn to Gerard Cassidy with decades of banking analysis, experience, experience with OURBC capital markets. UH. Jared Cassid, Jered Cassidy, wonderful to have you with us today.

What does it signal to Deutsche Bank that they have become a problem bank? According to the U s f D I C is, this company has struggled with the sacraft process. As you know, that's the annual stress test that the banks have to go through and they've not been able to pass it for the last couple of years. So it's no big surprise this news leaked out. Normally, these ratings by the bank regulators. They are part of the rating system called CAMEL, which is an acronym and

it's one trough five. If you're a four or five, you're a troubled bank, which is apparently what came out this morning, as you pointed out, with Deutsche Bank. So it means that this heavy lifting still to be done so that they get their internal house in order here in the United States, Jered, what does this mean to a bank to see the decline and shares? We have a ten percent decline off of the pre italy moment, there's a fact where the stock price is a stock price.

Do institutions, including the boards of directors of a given bank, do they care when they see a stock drop like this, and particularly drop into the single digit area, Tom, I think they do. I mean they have to take notice of any big stock price the clients, and so we've seen deutger has struggled as you and I have noticed all the last many years, and this is just another challenge that they have to confront. And so the steep

price decline, of course is troublesome. It's something that they have to address um possibly come out with the public statements to address it. So what's so important here? And I guess it goes back to the memories of another time and place not to be inflammatory, which is all slams in Gerard Cassidy to the short term paper market, pim Fox likes to talk about counter party risk and other ideas. Maybe it's commercial paper, short term paper. Come on, Jerry,

it's all about trust. Where's the trust now on the desk of Deutsche Bank. No, No, you're right. There's certainly a confidence factor that you have to address. Certainly, this company, you know, consolidated, is well capitalized. This is nothing like what we saw. Yeah, but that's a distinction, Gerard Cassy, This is important. This is a distinction between liquidity and solvency. Discuss that, please, what's the difference for our audience between

a given major banks liquidity and their solvency? No time, You're absolutely right. In fact, you know, the liquidity problem was why they eventually put UM meaning Brothers into the position and they ended up failing. But because of what we saw No. Seven oh eight, Deutscher and all the global banks have addressed the amount of liquidity they need

to carry because of the new BOSSAL requirements. So all of our banks, even banks that are considered to be troubled, and with this troubling too, with what came out, it's in my view it looks like it's more the internal um, internal systems and the internal reporting have to be really improved. It's not in measure of not having liquidity or capital

that I'm not. There's not really the issue. So there's plenty of aquidity here for any you know, for Douga Bank and again all our global banks because of what the regular is they've done past two thousand and eight and two thousand and nine. But then they go back to the stock price. If you're just joining us folks worldwide, we're wanted to bring a Gerard Cassidy RBC Capital Markets for a few more minutes, pre Italy ten point five zero euros and we're now down to nine point four

four euros. We found a modest bid here to be retested in the coming excuse me, in the coming uh minutes, Gerard Cassidy, I want to go back to the stock price. Who's selling is this hedge funds? Is this speculators? Is this long only by side institutional clients who are either selling or they're being told by their general counsel to sell. Yes,

it's tough to determine who the sellers are. Certainly it is we've seen, um the active traders, the hedge fund traders certainly will move very quickly on news like that. But again it's hard to really determine, you know, unless there's huge blocks going across and and the trading desks tell us you know that it was a long only,

so it's really hard to determine who's telling. But again, as you know that this company is struggling with many issues, this is just more of the more recent ones, obviously this morning, but they are still wrestling with how do they downsize their capital markets business and in the number of employ years let go that is also reading on this story. Very valuable to direct cast Andy, Thank you so much with OURBC Capital Markets on short notice here. Yeah,

thanks for listening to the Bloomberg Surveillance podcast. Subscribe and listen to interviews on Apple Podcasts, SoundCloud, or whichever podcast platform you prefer. I'm on Twitter at Tom Keene. Before the podcast, you can always catch us worldwide. I'm Bloomberg Radio