Italy Pushed to the Brink by ECB Fiscal Orthodoxy
Some of us have been warning for months about the crisis scenario that is accelerating today in Europe. In particular, I have noted that the European authorities were pushing Italy down a dangerous path, in similar fashion to what they did to Greece. The formula is deadly: force budget tightening on an economy that is already shrinking or on the edge of recession. This shrinks the economy further, causing government revenue to fall and making still further tightening necessary to meet the target budget deficit. The government's borrowing costs rise because markets see where this is going. This makes it even more difficult to meet the targets, and the whole mess can spiral out of control.
Wednesday, financial markets reacted violently to this process in Italy, with yields on both ten-year and two-year Italian government bonds soaring past 7%. Let's do the math.
One year ago, Italy could borrow at 4% for ten-year bonds. Today, these yields went as high as 7.7%. Multiply this difference, 3.7%, by the €356bn ($491bn) that Italy has to refinance over the next year. That's €13.2bn ($18.2bn) in additional borrowing costs, or about 1% of Italy's GDP.
Italy has agreed to deficit reduction of 3.9% of GDP by 2013, with about 1.7% of it coming over the next year. Prime Minister Silvio Berlusconi has announced he will resign, in part because of the political difficulty of making these changes in a weak economy. Now add another 1% of GDP to make the same target – and that the target will move because the economy will likely shrink further – and you can conceive that Italy is not going to make these targets. Which is what the bond markets are imagining right now.
In fact, the bond traders can be more imaginative than that. They have noticed that when Portugal and Ireland's bond yields went above 7%, they quickly soared into the double digits. These governments were then forced to borrow from the IMF and the European authorities, instead of relying on financial markets.
The European authorities are not prepared to deal with such a situation. Italy is the world's eighth largest economy, and its $2.6tn debt is much more than that of Ireland, Portugal, Greece and even Spain combined. Clearing houses in Europe have recently begun to require more collateral for Italian debt, which has also unnerved markets. A lot of Italy's debt is held by European banks, and the fall in Italy's bond prices also causes problems for their balance sheets, increasing the risk of a worsening financial crisis that is already slowing the world economy.
What can be done about this? The European Central Bank (ECB) reportedly intervened heavily in the Italian bond market, and its purchases are probably what brought Italy's bond yields down somewhat from their peaks. But this is not nearly enough to resolve the crisis.
The ECB is the main problem. It is run by people who hold extremist views about the responsibility of central banks and governments in situations of crisis and recession. Even as facts contradict them on a daily basis, they cling stubbornly to the view that further budget tightening will restore the confidence of financial markets and resolve the crisis.
Governments must take "radical measures to consolidate public finances," said ECB executive board member Jurgen Stark Tuesday. But of course, these measures will only pour more fuel on the fire, by pushing Europe further towards recession and exacerbating the debt and budget problems of the weaker eurozone economies. And the new head of the ECB, Mario Draghi, just a week ago dismissed the idea of the central bank playing the role of lender of last resort – a traditional role for central banks.
ECB authorities think they have already done too much by buying $252bn of eurozone bonds over the past year and a half. But compare this to the US Federal Reserve, which has created more than $2tn since 2008 in efforts to keep the US economy from sinking back into recession. The ECB could put an end to this crisis by intervening in the way the US Federal Reserve has done in the United States. But they continue to insist that this is not their role. That is the heart of the problem, and until this policy is reversed, it is likely that the European economy will continue to worsen.