By
engulfing Italy, the euro crisis has entered a perilous new
phase, with the single
currency itself now at risk
Italy
and the euro: On the edge
The
Economist, July 14th 2011
For
more than a year the euro zone’s debt drama has lurched from
one nail-biting scene to another. First Greece took centre
stage; then Ireland; then Portugal; then Greece again. Each
time European policymakers reacted similarly: with denial and
dithering, followed at the eleventh hour with a half-baked
rescue plan to buy time.
This
week the shortcomings of this muddling-through were laid bare.
Financial markets turned on Italy, the euro zone’s
third-biggest economy, with alarming speed. Yields on ten-year
Italian bonds jumped by almost a percentage point in two
trading days: on July 12th they breached 6%, their highest
since the euro was created. The Milan stockmarket slumped to
its lowest in two years. Though bond yields subsequently fell
back, the debt crisis has clearly entered a new phase. No
longer confined to the small peripheral economies of Greece,
Ireland and Portugal, it has hurdled over Spain, supposedly
next in line, and reached one of the euro zone’s giants. All
its members, but especially Germany, face a stark choice.
Consider
the stakes. Italy has the biggest sovereign-debt market in
Europe and the third-biggest in the world. It has €1.9
trillion ($2.6 trillion) of sovereign debt outstanding, 120%
of its GDP, three times as much as Greece, Ireland and
Portugal combined—and far more than the €250 billion or so
left in the European Financial Stability Facility (EFSF), the
currency club’s rescue kitty. Default would have calamitous
consequences for the euro and the world economy. Even if the
more likely immediate prospect is sustained stress in the
Italian bond market, that will surely prompt investors to flee
European assets, making the continent’s recovery ever
harder. Meanwhile in the background there is the absurd
pantomime of Barack Obama and congressional Republicans
feuding over how to raise the federal government’s debt
ceiling to stave off an American “default” (see article).
That may have distracted American investors briefly; once they
realise how much is at stake in Italy, it will not help.
From Rome
to Brussels, Frankfurt and Berlin
The
proximate cause of this week’s scare lies in Italian
politics, and a row in which Silvio Berlusconi, the prime
minister, hurled playground insults at Giulio Tremonti, the
finance minister, over a new austerity budget. Add in the
underlying concerns about the Italian economy’s feeble
growth rate, and investors are understandably worried about
the Italian government’s ability to shoulder its huge debt.
In
theory, these concerns should be easy for a grown-up
government to address. After all, Italy, for all its faults,
is not a big Greece. Its debt burden has been high but stable
for years. Its primary budget (ie, before interest payments)
is in surplus. It has a record of cutting spending and raising
taxes if it needs to do so: in 1997, when it was trying to get
into the euro, its primary surplus was 6% of GDP. By European
standards its banks are decently capitalised. High private
saving means that much sovereign borrowing is funded at home.
In
practice, though, there is seldom a clear line between
illiquidity and insolvency: if the price Italy must pay to
borrow rises high enough for long enough, its debt will
eventually spiral out of control. And Italy’s prospects are
being overwhelmed by the contradictions and uncertainties in
Brussels, Frankfurt and Berlin, where respectively the
Eurocrats, the European Central Bank (ECB) and Germany’s
chancellor, Angela Merkel, have all vainly tried to follow two
contradictory goals—namely, avoiding any formal default on
Greek debt, while also avoiding an open-ended transfer from
richer European countries to the insolvent periphery (see
article).
To
be fair to Mrs Merkel and Europe’s other leaders, they have
not chosen to muddle through merely out of cowardice, though
there has been plenty of that, but because the euro-zone
countries are profoundly divided. They cannot agree on who
should bear the cost of today’s crisis: should it be
creditors (through a write-down), debtors (through austerity)
or the Germans (through transfers to the south)? And they have
not decided whether the long-term answer is a fiscal union, or
not. Investors are thus unclear about how badly they may be
hit. With Europeans in such a muddle over little Greece, no
wonder investors are so terrified by big Italy.
Cometh
the hour, cometh the Eurobond
What
is to be done? This newspaper has long argued that
muddling-through must be replaced by a comprehensive strategy
based on three components: debt reduction for plainly
insolvent countries; a recapitalisation of the European banks
that will suffer from that restructuring; and the building of
a firewall between the insolvent and the rest.
Debt
reduction must begin with Greece, the country that is most
obviously bust. However the restructuring is pitched, Greece
will be in default, so a plan to recapitalise banks hit badly
by this, starting with Greece’s own, will be needed too. The
results of stress tests, due on July 15th, should show how
much more help is required. There may have to be a similar
restructuring for Portugal and Ireland.
The
task of building a firewall around the solvent core, including
Spain and Italy, has to be shared between the countries at
risk and the euro zone as a whole. Italy needs to pass its
budget speedily—and also push through long overdue
structural reforms. Its challenges are not only, or even
mainly, about fiscal austerity, but about making the economy
grow. As for the euro zone, short-term help may have to come
from the ECB buying Italian bonds (difficult politically
because the next head of the ECB will be Mario Draghi, the
boss of Italy’s central bank). Soon though the euro zone may
well have to expand the EFSF and allow it to issue jointly
guaranteed “Eurobonds”.e
That
is a huge political leap—especially for Mrs Merkel. Germany
is firmly opposed to any solution that could imply open-ended
transfers to feckless southerners; so are several other
northern European countries, not least because guaranteeing
others may raise their own borrowing costs. It is not a
pleasant option. But the alternative could be the end of the
euro. That is the horrible lesson of this week.
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