Last week we witnessed a flight to quality within the euro zone government bond market. The yield on 10-year German government bonds dropped a record 35 points last week. German 10-year bonds now yield 1.82 percent. Meanwhile, the yield on 10-year Italian government bonds continues to rise, last quoted by Bloomberg at 6.37%, a record 455 basis points higher than German government bonds.
Clearly, Italy is now the biggest focal point of the European sovereign debt crisis. And, make no bones about, while the immediate concern for Italy is liquidity, at heart the European Sovereign Debt Crisis is a solvency crisis. Let’s take a look at Italy to see why.
The “Complete Strategy”
On October 26th, the EU announced to great fanfare that it had hammered out a “complete strategy” to deal with the ever-widening European sovereign debt crisis. The text of summit statement showed three pillars upon which this strategy rested.
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Sustainable public finances and structural reforms for growth: “The European Union must improve its growth and employment outlook, as outlined in the growth agenda agreed by the European Council on 23 October 2011… All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms.”
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Stabilisation mechanisms: “We agree on two basic options to leverage the resources of the EFSF: providing credit enhancement to new debt issued by Member States, thus reducing the funding cost…; maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles.”
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Banking system package: “There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures… Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”
The first of three pillars addresses solvency of euro area national governments while the second addresses liquidity. The third addresses both the liquidity and solvency of euro area banks. But will this solve Italy’s problems?
Italy
Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.
As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.
How can Italy get out of this trap?
Lower interest rates: The plan presented by the EU was to relieve Italy of its interest rate burden by leveraging the European bailout facility, the EFSF. In order to do this, the Europeans need a “combination of resources from private and public financial institutions and investors”. We know that European banks are undercapitalised and European countries are in the midst of a sovereign debt crisis. So no funds are going to be forthcoming there. The United States is having its own fiscal battles and cannot take the lead. That leaves the biggest developing countries, China, Brazil and India and oil rich sovereigns to bail out the Europeans. The Chinese have already said they are not going to get involved and the amount of resources Europe can get from elsewhere is not nearly enough to backstop Italian government debt, the third largest government debt load in the world unless the Europeans are relying on aliens to fund them. So this pillar of the three-legged stool is broken – at least for an economy the size of Italy’s.
Growth: Given the fact that Italy has one of the lowest ratios of births to deaths in the world, it also has a rapidly aging society, which limits potential economic growth. Even if domestic GDP expands by a wildly optimistic 2 percent per year – it has expanded less than one percent over the last decade – you would need 3% growth from exports in order to stabilise the debt to GDP ratio at 120% at prevailing interest rates. That is never going to happen. So this leg too is bust.
Austerity: The Europeans are pushing Italy to make structural reform. But the Italian government has been unable to make these reforms. Prime Minister Berlusconi priorities seem to be elsewhere and his government is weak; likely the government will collapse. Even so, Italy’s labour minister Maurizio Sacconi warns that rushing through the labour market reforms which the EU demands risks creating the preconditions for a wave of terrorism. Wow. Do you really think, the Italian government, which seemed to have a different governing coalition almost every year for most of the post World War II era, is going to be able to push these kinds of draconian reforms through? And I haven’t even mentioned budget or public pension cuts.
The Italians don’t have a leg to stand on.
Monetisation
This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.
The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.
Now that the credit crisis has moved on to sovereign debt, the central bank can play this role with sovereign debt as well. The best way to accomplish this task would be to start buying enormous quantities of sovereign debt, inducing a huge shift in the price/interest rate of those assets. Only afterwards, the ECB would announce that it was prepared to supply unlimited liquidity to stand behind these assets at specific target interest rates and would do so at the most inconvenient moments for speculators wishing to make a quick euro. (Update: see comments of a similar nature after this was written from Willem Buiter at the bottom.)
The point would be twofold:
- Market participants would understand that the ECB had unlimited means to back up threats with action, the stress clearly on the word unlimited.
- Market participants would understand that the ECB intended to penalise speculators by targeting them with its unlimited liquidity.
As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.
The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will.
–Three options for the euro zone: monetisation, default, or break-up, Nov 2011
I wrote these paragraphs one year ago and I see nothing that has occurred since then which makes me want to change anything. In fact, the events of the past year make me think this is all the more likely. Italy was not a factor then; it was Spain which was the problem. Italy has the third largest government bond market in the world. In July, I also mentioned that Italy owes German banks 116 Billion euros. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. And as I outlined above, the route to a sustainable solvency path that leads to liquidity for Italy is blocked at every path. Italy will continue to pay a huge premium for its debt. The only way to ensure Italy’s medium-term solvency is to have it borrow in a currency whose creator is credibly committed to creating an unlimited supply of money in order to backstop Italy’s debt if necessary.
At present, the ECB is buying just enough bonds to send a message to Spain and Italy that they need to live up to their austerity quid pro quo or else the ECB will stop buying. The ECB wants to prevent ‘free riders’ from making the euro a weak currency. But, let’s be clear, a currency with “no lender of the last resort” was a ridiculous concept from the start. The crisis we are witnessing now was always going to happen. As much as the ECB resists it now, they have limited choices: monetise or face a global economic collapse. The longer they wait, the worse it will get.