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.
Translation:
… 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.