EFTA01071566

Eye on the Market I 
November 4,2011 
J.P.Morgan 
Topic: The intersection of politics and economics comes to a head in the US, Italy and Greece; Chart of the Year 
I can't remember a time when stock price movements were quite so heavily affected by macroeconomic developments. One of 
our models indicates that 75%-80% of stock price movements for the S&P 100 are now explained by macro forces, a new all-
time high. With that in mind, here are the latest developments in countries facing the political realities of fiscal austerity. This 
is not a fun time to be a politician in the birthplace of Western Democracy (Italy, Greece), or its 18th century offshoot (the US). 
The United States, and the Incredible Shrinking Expectations for the Joint Select Committee on Deficit Reduction 
The chorus of voices calling for compromise and "big bang" long-term deficit reduction includes a bipartisan group of 100 
House Democrats and Republicans in a letter to the Deficit Reduction Committee (DRC). However, so far, most policy 
proposals we hear about are far less ambitious, while others are already back-tracking on the Budget Control Act: 
• A November 3 letter to the DRC by 33 Republican Senators calling for tax reform that lowers rates with no net tax increase 
• A plan to have the DRC agree to a few hundred million of revenue increases, but then assign the task of finding them to 
other congressional committees, whose decisions would not be binding 
• Using lower forecasts of war funding assumptions (declines in "Overseas Contingency Operations") to get to the targeted 
deficit reduction, rather than tackling structural deficits 
• If the DRC does not come to agreement on $1.2 trillion in deficit reduction, there are mandated, "sequestered" cuts that 
would impact Medicare payments, security/defense allocations and non-defense spending. The latest reports indicate that 
Republican senators are working on legislation to derail mandated cuts to on defense spending, which of course has led to 
calls from Democratic legislators to defuse mandatory domestic spending cuts if defense cuts are derailed 
We wrote a piece on why financial markets are likely to pay 
close attention to the DRC (the paper, which was entered into 
Senate testimony on October 4ih by Maya MacGuineas of the 
Committee for a Responsible Federal Budget, can be found 
here: http://www.politico.com/pdf/PPM223 financial.pdf). The 
accompanying chart is the starting point in the discussion. As 
shown, even if the DRC does find $1.2 trillion in deficit 
reduction over ten years as per the Budget Control Act, the debt 
trajectory of the United States is still not stabilized, and will 
continue to rise based on CBO (and our) projections for growth, 
spending and revenues. Celebrating the Committee's ability 
to get to $1.2 trillion in deficit reduction would be like 
having a national holiday commemorating the U.S. military 
victory over Grenada. Something like $3 trillion in 10-year 
deficit reduction would be needed to ensure that the United 
States controls its own economic destiny. The current imperative for the US is job growth, which cures a lot of ills, so why 
consider tax increases and spending cuts at all? One of the common denominators of countries whose private sector job growth 
is healthy is the backdrop of a public sector that is not at risk of a sudden, destabilizing withdrawal of foreign capital. What's 
happening in Italy and Greece are examples of what can take place when that is no longer the case. 
CB0June Alternative case • 
Budget Control Act: Automatic Cuts 
Budget Control Act: Joint Committee proposal. 
15 trillion Gap 
CBO August Baseline 
U.S. long-term debt scenarios 
Net debt to GDP, percent 
110 
100 
so 
80 
70 
60 
50 
40 
30 
2004 
2006 
2008 
2010 
2012 
2014 2016 2018 
Source: Congressional Budget Office, J.P. Morgan Private Bank. 
2020 
Italy, Economics > Politics, and the Chart of the Year 
To keep this note limited to 3 pages, we cannot spend too much time describing the workings of the Italian Parliament (there 
have been 14 Italian governments since the inception of the European Monetary Union). As reported by II Corriere, finance 
minister Tremonti warned Prime Minister Berlusconi that if he did not step down, there could be a "disaster in financial 
markets"; Berlusconi replied that the problems were more a function of Tremonti "speaking ill about me". All we can say is 
that a technocratic government may be getting closer if Berlusconi continues to lose support in the Popolo della Liberta, perhaps 
led by former EU Competition Commissioner Mario Monti (known in some circles for his decision to block the 2000 
GE/Honeywell merger, and fines levied against Microsoft). Monti is a supporter of EU Federalization; although given the 
subsidies for countries like Italy that Federalization implies, I can't imagine why any Italian economist would ever oppose it. 
While markets might welcome a technocratic government, keep in mind that the lesson of the last 2 years is that in the long run, 
economics trump politics. Here are 5 things to keep in mind about Italy's economy, with references to when we included the 
corresponding charts in the EoTM: 
If it doesn't, be prepared to read more editorials like this: http://news.xinhuanet.com/english2010/indepth/201 I-08/06/c I31032986.htm 
EFTA01071566

Eye on the Market I 
November 4, 2011 
J.P.Morgan 
Topic: The intersection of politics and economics comes to a head in the US, Italy and Greece; Chart of the Year 
1. Other than during its participation in WWI/WWII, Italy's debt is at the highest level since reunification in 1861 (Sep 21) 
2. Italy has not experienced the labor competitiveness adjustments seen in Ireland, has among the worst "production time per 
unit" in Europe, and relies more on foreign capital than at any time since 1975 (Sep 21) 
3. The decline in Italy's debt-to-GDP ratio during the late 1990's was heavily based on EMU convergence which resulted in 
Italian interest expenditures to GDP falling from 11% to 4% (Oct 5); this is a one-trick pony that is now going in reverse 
4. The primary budget surplus Italy ran in the 1990's was based mostly on higher taxes rather than reduced spending (Oct 5), 
providing less of a blueprint for the current period, when the primary surplus will also need to be around 4%-5% 
5. Loan loss provisions held by Italian banks on their performing loans are 15%-25% of comparable levels in the US (Nov 1) 
On top of these structural issues, the latest surveys show a 
sharp decline in output in Italy, suggesting that a recession is 
coming (see right). Our Chief Economist Michael Valcnin 
estimates that even with a primary surplus of 3%, if 
accompanied by a modest recession of 1.5% of GDP in 2012, 
5% interest rates and 1% inflation, Italian debt would rise 
rather than fall over the next 3 years. 
The ECB would like to see the Italian Parliament do the 
following: reform collective wage bargaining, allowing 
companies to tailor wages and working conditions to firm-
specific needs; review rules regulating hiring and dismissal of 
employees; create a fund to help with worker reallocation; 
and tighten pension eligibility criteria. Whether this would 
unleash a productive surge in Italy is anyone's guess2. Italy's 
stubborn growth and productivity gap with Germany brings us to the Chart of the Year. 
Plunge in Italian manufacturing survey points to recession 
PMI, output indox.sa 
65 
60 
55 
so 
as 
40 
35 
30 
Jun•97 
Dec•00 
Source: Markle. 
Jun•04 
Dec-07 
Chart of the Year. This was a difficult choice, as we have 
shown 511 different charts in the Eye on the Market so far 
this year. To be eligible, the chart has to capture a trend that 
had a large impact on markets, and also has to be easy to 
understand (not the case for all our charts). The winner: the 
one showing the divergence between German and Italian 
industrial production, which began like clockwork when 
the Euro was adopted. Instead of explaining the reasons 
that this chart won, I will summarize as follows. If I told you 
that this economic outcome was the by-product of belated 
efforts by the Allied Powers of the 1940's to sow dissension 
and discord in the ranks of the Axis Powers, it would make 
more sense than to discover that this is the result of an 
economic model willfully adopted by the countries 
themselves. As a reminder, Italy has more debt outstanding 
than Germany, despite being a considerably smaller economy. 
Industrial production in Germany and Italy 
Index,12/31/1998.100.sa 
140 
130 
120 
110 
100 
90 
80 
70 
1986 
1990 
1994 
1998 
2002 
2006 
2010 
1982 
Euro exchange rate fixed 
Germany 
Source:OECD,GaveKalSecurnies. 
Jun-11 
Greece and Chaos theory 
At times like this, it's worth remembering that "chaos" is a word of Greek origin (VO4 Over the past 48 hours, Greece has 
been contemplating public referendums (the way Ancient Athens used to sort things out), early elections, national unity 
governments, etc. As with Italy, the Greek government needs an explicit vote of support, either from the opposition parties or 
the public at large, to continue with its failed, IMF-approved experiment of fiscal austerity within the confines of a fixed 
exchange rate. Markets might like the fact that there will be no referendum or early elections; I think that is a mistake. The 
political and social fabric of Greece is in shreds; the lack of a safety valve allowing public consent to continued austerity is 
potentially dangerous. A national unity government designed to simply re-approve austerity plans and secure the next EU 
disbursement may have no more political legitimacy than the current one. 
2Unfortunately for Italy, of all reforms, labor market reforms are the ones with the largest short-term negative impact on growth. See 
"Fostering structural reforms in industrial countries", IMF, 2004, Chapter 3, Exhibit 3.9. 
2 
EFTA01071567

Eye on the Market I 
November 4, 2011 
J.P. Morgan 
Topic: The intersection of politics and economics comes to a head in the US, Italy and Greece; Chart of the Year 
Why isn't the recently proposed debt exchange calming things down? The proposed debt exchange is designed to include 
the "voluntary" participation of European banks, which own 85 billion out of Greece's 375 billion in debt. There's another 100 
billion or so held by a variety of private sector entities that might participate, but the incentives at the current time are unclear3. 
The remainder is held by the IMF, ECB, EU and Greek Social Security Funds, which are reportedly not participating. As a 
result, as shown in the first chart, Greece's debt burden is still crushing, even assuming 50% debt forgiveness and 150 billion of 
participation. All the scenarios are bad, even the one crafted by the IMF; compare them to prior post-restructuring debt levels in 
Mexico and Argentina. The EU approach to Greece from the beginning has violated the principles the official sector 
learned a long time ago: you cannot impose austerity from outside without visible contributions by external creditors that make 
the country's finances sustainable (see box). 
Greek post-exchange debt levels, with some comparisons 
Debt to GDP. percent 
200% 
185% 
170% 
Greece J.P. Morgan central scenario 
155% 
140% 
125% 
Greece IMF ECB EU baseline 
110% 
95% 
80% 
Argentina 2001 post-restructuring debt to GDP 
65% 
50%  Mexico 1990 post-restructuring debt to GDP 
35%  
'09 '10 
'11 
'12 
'13 14 '15 
'16 
'17 
'18 19 '20 
Source:EU,J.P. Morgan Securities LLC, Banco de Mexico, Ministerio de 
Economia y Production. 
A lesson that EU policvmakers foreot to read 
From the World Bank's archives, in 1990: 
"Mexicans have made such enormous adjustments, 
accepted such a large reduction in living standards, that 
any package without an extensive and visible 
contribution by external creditors would not be 
acceptable domestically" 
"Mexico's External Debt Restructuring in 1989-90", 
June 1990, S. van Wijnbergen, World Bank Regional 
Working Paper 424. 
For what it's worth, I do not subscribe to the economic orthodoxy that it is axiomatic that Greece would be worse off 
defaulting and exiting the Euro. This is speculation, and my opinion doesn't matter anyway. But I find it interesting that 
some people who have misjudged the severity of the EMU crisis from the beginning are the voices most convinced that an exit 
from the EU would result in a greater disaster for Greece worse than the one that is already upon them. 
Let's start with this table. These are estimates of Greece's 
"primary balance", the budget deficit they must close by increasing 
taxes or cutting spending, before considering interest expense. 
The bottom line: by 2012, Greece will be much closer to being 
in balance before interest, raising the incentive to default on its 
external debt. A default and exit from the Euro would most likely 
knock Greek GDP for a loop (again), which could reintroduce a 
primary deficit. But there's no question that Greece is closer now 
than it was a year ago to being able to consider a default/exit 
option that does not automatically entail another massive fiscal 
contraction. 
Greece primary balance, % of GDP 
Source 
2010 2011 2012 
As of: 
JPMS LW 
-4.90 -2.30 
0.80 
10/28/2011 
IMF/ECB/EU 
-4.90 -2.30 
1.40 
10/28/2011 
IMF 
-4.95 -1.29 
0.79 
Sep-11 
OECD 
-5.08 -1.93 -0.94 
7/1/2011 
Eurostat 
-4.90 -2.80 -1.80 Spring 2011 
BotA/ML Research -4.90 -1.30 
0.80 
9/26/2011 
The unshakable conclusion that Greece would be worse off if it left the European Monetary Union is also inconveniently 
challenged by the recent recovery in Iceland (see Appendix), the recovery of the United Kingdom in 1992 after leaving the 
ERM (Exchange Rate Mechanism), and the last 40 years of history regarding fiscal adjustments, growth and currency 
devaluation. There is very little precedent for what the Europeans are trying to do: large fiscal adjustments at a time of low 
growth and without currency devaluation (see orange circles on chart below). These efforts are in stark contrast to the last 40 
years of history in Europe and Latin America regarding how such crises are typically resolved (yellow circles). 
3 A lot depends on whether participants in the first exchange (if it happens) could be defaulted upon a second time in the future. In other 
words, if any new bonds are cross-defaulted with existing Greek debt, and in 2012 Greece defaults on those who did not participate the first 
time, there's no mason to participate today, since you will be defaulted upon twice. To avoid this outcome, the bonds offered in the current 
exchange would have to either be subject to UK law (as opposed to Greek law), or collateralized in some reliable way. 
3 
EFTA01071568

Eye on the Market I 
November 4, 2011 
J.P.Morgan 
Topic: The intersection of politics and economics comes to a head in the US, Italy and Greece: ('hart of the Year 
Fiscal adjustments, then and now 
4.0% 
3.0% 
2.0° 
O 
2010 EMU fiscal adjustments 
Prior European 
and Latin 
adjustments. 
1.200 . 
0 
0 
900 - 
600 - 
300 . 
Iceland took the normal route, and is now recovering 
Sovereign credit def ault swap spread. basis points 
CurrencyDevaluation, % 
20% 
40% 
60% 
80% 
100% 
0 
Source:International Monetary Fund, Organization for Economic Co-
Operation and Development, Barclays Capital, Bloomberg. 
Greece to 5700 t 
Iceland 
Italy 
Jun 07 
Feb-08 
Oct-08 
Jun-09 
Feb-10 
Oct-10 
Jun.11 
Sourco:J.P.Morgan Securities LLC. 
There is no question that there would be severe costs to Greece if it defaulted and exited the Euro. If Greece had to rely 
on its central bank to finance budget deficits, they would risk a substantial rise in inflation (which could erode the devaluation 
benefit), and in turn, further damage the credibility of the Bank of Greece. There could also be disruptions to trade finance 
(which could be ameliorated by the IMF in ways that more constructive for Greece than what they are doing now). The 
question is whether exiting offers the chance of something better for Greece than the certainty of failure associated with staying 
in the Euro. That is what Greece is in the process of debating; a temporary government is unlikely to be the last word on this. 
Michael Cembalest 
Chief Investment Officer 
The Sun Also Rises: Iceland's post-devaluation recovery 
Unlike the rest of Southern Europe, Iceland pursued the traditional formula: fiscal austerity, a large currency devaluation (which 
led to a rapid improvement in its current account deficit), an IMF loan and most importantly, the refusal to take on the 
obligations of Icelandic banks. Iceland's debt/gdp ratio is now around 100% (having risen from 40% a few years ago), so why 
are Iceland's credit spreads so much tighter than in Ireland and Portugal and tighter than Italy? Iceland suffered a huge spike in 
inflation and unemployment in 2009, and a terrible collapse in GDP and private consumption as well. But by 2010, the standard 
adjustment started to play out, in which GDP, trade, private consumption and capital 
spending are now rebounding. Inflation, which hit 18% in 2009, is back at 2%. The 
budget deficit is 4.5% of GDP, requiring less austerity going forward than Southern 
Europe. Iceland is expected to grow at around 3.5% to 4.0%, which helps solve a lot 
of problems, and puts the government debt ratio on a trajectory to decline rather than 
rise. Iceland's unemployment has risen to 9%, but is stable and now half the rate in 
Southern Europe. A fiercely independent country, it also controls its own destiny. 
The material contained herein is intended as a general market momentary. Opinions expressed herein are those of 
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