Italy’s debt woes and Germany’s intransigence lead to Depression

Disclaimer: These last five pieces on the impact of Italy’s potential insolvency on the sovereign debt crisis are not advocacy pieces. They are actionable macro analyses – predictions of what I see as likely to occur.

Michael Pettis liked my recent piece on vendor financing in the euro zone. The key point he wrote me – and which he reiterated today – is that bad policies in “the surplus as well as in the deficit countries are at the root of the trade and capital inflow imbalances to which this crisis is the response”.  I agree with his contention that it is pointless to insist on adjustments only in the deficit countries.

That said, Michael agreed, however, that the euro crisis is not just a liquidity crisis. The European Sovereign Debt Crisis is a solvency crisis too. Countries like Italy are simply not going to be able to grow their way out of the problem. Everyone is recognizing this now. Until Italy was at the heart of the crisis, we could all delude ourselves that this crisis could be met with crushing levels of austerity in the periphery, even if that forced the economies there into depression. If Spain’s debt woes and Germany’s intransigence lead to double dip, then Italy’s debt woes and Germany’s intransigence lead to a Depression (with a capital ‘D’).

So, how the heck do we get out of this morass? My argument has been that with the central bank as a lender of last resort, solvency is meaningless for a government borrowing in a currency its central bank creates. In a nonconvertible floating exchange rate world, the adjustment mechanism is the exchange rate, not the interest rate. The last twenty years in Japan tell us that.


… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

Credit Writedowns, Oct 2009

That’s a soft depression scenario where the countries with a true lender of last resort can backstop without problems. In the euro zone, the ECB is not a lender of last resort… yet. And so the solvency issue cannot be postponed, monetised or inflated away and comes to a head. In fact, had the ECB been allowed to intervene as a lender of last resort earlier when just Greece was on the line in March 2010, we wouldn’t be here at all. Since then, the ECB has intervened only as a quid pro quo for more economy-deflating austerity, making things worse. And when they have bought periphery bonds they have been timid to prevent the currency-weakening moral hazard of ‘fiscal profligacy’. Credible lenders of last resort use price, not quantity signals. Everything in the sovereign debt crisis that has transpired since March 2010 is directly attributable to the ECB’s not acting as a lender of last resort.

As for Italy’s solvency, here’s what we know: Italian government debt is almost 120 percent of GDP. Since Italy pays over 6% for two-year money, rolling over debt contracted at favourable yields in 2008 or 2009 becomes excruciatingly onerous. Slow growth Italy’s debt to GDP spirals higher and higher at these levels. At German yield levels, Italy can sustain its growth indefinitely because it has a primary surplus already. I covered a lot of the ground in my last three posts Why questioning Italy’s solvency leads inevitably to monetisation, Why Investors will buy Italian bonds after ECB monetisation and Italy! Italy! Italy!

Here’s the thing: distinguishing between insolvency and illiquidity is a tricky subject because liquidity crises are the market’s way of shaking out the insolvent. Liquidity crises are always solvency crises. The question is about determining which debtor will not be able to repay future principle and interest in a world of incomplete information. If the questionable debtors are large enough, this leads to panic and a wider liquidity crisis that stresses the balance sheets of everyone, including the insolvent debtors. Indeed, the insolvent almost always are shaken out and bankrupted by this process (or are bailed out by government). The problem is that the shake out process kills a lot of other debtors too. If the crisis is large enough, a Depression results.

So, we are now faced with a question: Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

  1. Bruce says

    If the ECB does this for Italy, won’t they then be required to do it for the whole EZ (e.g. Spain Portugal Ireland etc.)?

    1. Edward Harrison says

      Yes, eventually yes. That’s why the EZ will have to move to tighter fiscal integration (to prevent ‘free riders’), which probably means some within the periphery will leave.

      1. David Lazarus says

        I doubt that the euro will survive. There is far too much national self interest to keep it whole. If it does survive it will be substantially smaller. At the moment only those nations with very small deficits will make it through. That will mean the end of the banks, as the debts will have to be written off.

  2. Max says

    If the ECB backs government bonds, then the crisis would end, but the Euro system would be destroyed. It can’t work if every country has a license to spend unlimited amounts. Imagine if every state in the U.S. could print money. There would be no restraint.

    So I think the authorities will choose depression. And the countries that don’t like it can leave the Euro.

    1. Edward Harrison says

      “The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.

      However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.”

      1. David Lazarus says

        It will need some harmonisation of taxes as companies might move within the zone to get lower taxes as Ireland has benefited from. Though considering the expulsion of Greece has opened the prospect for Ireland then it would solve that problem as well. With Ireland out of the Eurozone it will reduce tax arbitrage within the eurozone as well.

  3. craig davis says

    very insightful analysis edward, i read all your recent articles tonight and i learned a lot. i have two questions for you..

    1.) when do you envision the ecb finally accepting this reality and going all in with its italian bond backstop?

    2.) you stated earlier that the ez is already in recession, at some point (soon?) won’t the budget deficits for greece, italy, portugal, spain, france etc explode from current levels and make their perilous debt situations far worse? i understand how the ecb backstop would effectively reduce their borrowing costs, but isn’t that merely a temporary fix until the problem of massive new (unanticipated) debt gets thrown into the equation? thanks!

  4. Mike says

    Time to stockpile food, water, ammo.

  5. Anton says

    You are absolutely right that the ECB must become the lender or last resort but unless they print and do not sterilise, they need operationally to have a EU treasury. They cannot operationally be the lender of last resort QE style aka US or UK without a EU treasury. That does not absolve them from the responsibility to print and not sterilise but I think that everyone will agree that this is politically less feasible than QE “printing/lender of last resort” function. In fact, I believe that unless both the Fed and the BoE actually print and NOT sterilise we are not going out of this crisis. So, ultimately, yes ECB needs to become the lender of last resort but not before the politicians do create the EU treasury – this is not a point of principle but an operational necessity.

  6. Chris says

    I am trying to get a grasp of the bigger picture here – it seems to me that all of the issues we have had (US housing bubble, European sovereign debt burdens, etc) have been caused by easy money, or more specifically, the mispricing of risk by lenders. The EZ credit market for sovereign debt is currently going through a reset, with the market reasserting the need for discipline in fiscal matters. The ECB and Fed can step in to temporarily ease the speed at which this happens, but it seems to me it is inevitable that risk will be repriced and interest rates must rise, or else haircuts must happen to get us back to the point where markets are willing to lend again.

    In the near term, the US has benefited from the flight of capital to the presumed safe assets of treasury bonds and bills, but surely playing out the plot a bit further brings the crisis to our shores, and Japan’s as well.

    How to protect oneself and ones assets from this repricing of risk? Presumably we might see some inflation in asset prices as central banks step in to slow the adjustment via monetization. Gold and other hard assets might rise sharply. But after this period, as the inevitable repricing happens, surely every asset value must decline to reflect a world where perceived riskless assets (t bonds/bills) demand a higher interest rate. The timing of this shift will be difficult to play, seems to me, but crucial.

    1. David Lazarus says

      Yes the problems are a result of easy money and the worst thing is that the policy choices are for more of the same. The Basel rules do not look like an end to the risk models that we have and only look like a continuation of the risk models. The problem as I saw it was of solvency. The central banks flooded the banks with liquidity and slashed rates so that banks could earn their way out of insolvency. The fact that markets are pricing many countries bonds at higher rates shows that there has been substantial financial repression everywhere. That is true for the Austria to the US. At some point interest rates need to rise. Higher rates now could clear out even more bad loans, which central banks are desperately trying to hide.

      Yes the US has benefited recently from risk capital seeking safe havens. That might not change for some time as the largest liquid markets are still too risky.

      As to protecting yourself, there is very little that you can do. Another asset bubble or inflation has to impact negatively further down the line. Yes I agree with you that long term that asset prices across the board have to fall, and probably substantially. Gold is not a great way to store wealth. It can fall in price quite substantially without gold bugs buying it up. That is no different to property speculators that buy up all the property they can. While US real estate might have reached a floor it might fall if the banks collapse. We have had thirty years of debt finance asset speculation which could implode still further with a renewed banking crisis. We could be facing twenty years of deleveraging which will eliminate the prospects for many firms. The only issue is will the politicians be able to get the public to jump back on the debt bandwagon. My guess is not.

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