The Big Cannoli (Europe’s Catch 22)

At this point the crisis boils down to just one word: Italy, professor of economics and political science, Barry Eichengreen, writes in a commentary.  Italy’s debt is too big to restructure, and too big for the European Financial Stability to handle. Greece may have to restructure again and  France may have to take budgetary measures.  But those are sideshows, Eichengreen points out.

“Which distasteful option – inflation or Eurobonds – will be less revolting to German taxpayers? The German taxpayer will have to choose.  He is in a union with Italy.  And there is no way he can get out.”

Barry Eichengreen

Professor Barry Eichengreen goes straight to the heart of the European debt crises in this commentary article, syndicated by Germany is the only European country able to pick up the tab after a decade of unrestrained loan-inflating. And the big question is; are the people of Germany willing to do so?

While Europeans were off basking on the shores of the sunny Mediterranean, the crisis was not on holiday.

If you’re back, reading this, you will know that while you were away events entered a new, more ominous stage.

  • Volatility returned with a vengeance.
  • The creditworthiness of major French banks was called into question.
  • Germany’s credit default spreads began to rise, approaching levels previously scaled only at the beginning of 2009.

Here’s what professor of economics and political science at the University of California, Barry Eichengreen, writes in a recently syndicated article by the

“Lots to grasp, to be sure.  But at this point the crisis boils down to just one word: Italy.   Italy’s debt is too big to restructure and too big for the European Financial Stability to finance.  While crises are complicated beasts, there’s no reason to complicate this one.  Sure, Greece may have to restructure again.  France may have to take budgetary measures.  But those are sideshows.  The euro area will not live or die on their basis.  The euro area’s crisis is all about one thing:  that Italy’s debt might be unsustainable.”

The ECB has ramped up its secondary market purchases, buying some €22 billion of mainly, one assumes, Italian bonds last week.  What it really bought was time.  Time for the members of the euro zone and Italian leaders to finally make the hard choices.

“The official line is that this time will be used to put in place growth-friendly reforms so that Italy can grow out from under its debt mountain, or at least avoid being crushed by it.  Italy is moving now to balance its budget by 2013, a year earlier than previously. Unfortunately, this alone won’t be enough to stabilize the country’s debt-to-GDP ratio of 120 per cent.”  

At the beginning of the summer, the IMF was forecasting that Italian economy would grow by 1 per cent this year and very slightly faster, at best, after that.  Italy needs at least 1 per cent growth and 2 per cent inflation to ensure that the growth of nominal GDP exceeds the 3 per cent interest rate that is the best it can hope for.

Bad economic news from other parts of the world has rendered 1 per cent growth unattainable.  

This, in a nutshell, is what caused the Italian debt market, and European financial markets more generally, to blow up.

The budgetary measures that the Italian government has now proposed, moreover, will only diminish the country’s growth prospects. 

“Raising taxes on financial investments and corporations will not encourage investment.” 

The €13 billion of spending cuts and pension savings slated for the next 18 months will only depress demand further.

“What would help would be radical liberalization of the system of national labor contracts.  While the government is officially backing the idea, the only specifics we have is that any such initiative will be opposed by the country’s powerful trade unions.”

Maybe Italy will shake off the deep structural problems with labor contracts, tax compliance, and company and administrative law as a result of which its economy has been unable to grow.  Maybe 2012 will see the “miracle on the Mediterranean.”

If not, as seems more likely, and Italian growth slows, European policy makers will have two choices. 

One is a higher inflation target for the ECB.  There are a variety of ways of getting rates of inflation and economic growth to sum to more than 3, and more inflation is one of them.  The ECB could stop sterilizing its purchases of Italian bonds.   Given stagnant demand and contractionary fiscal policies, it might have to ramp up those purchases still further to ensure that prices rise at a 3 to 4 per cent annual clip. 

Fortunately, if Europe has one thing in abundance, it is debt securities for the ECB to purchase.

The only other option is Eurobonds.  Serious Eurobonds.  

Halfway houses, for example dividing sovereign debts into a first tier up to 60 per cent of each country’s GDP that will be guaranteed by euro area members as a group, and a second tier that will remain each nation’s responsibility, will no longer cut it.  Italy would presumably be asked to make a pro rata contribution to the fund servicing the Eurobonds.  And it would still have debt in the amount of 60 per cent of its GDP for which the Italian nation alone was responsible.  

The combination would not render its position sustainable in the absence of growth.

“The only workable solution is full pooling of existing debts and having member states contribute to payments on it according to their respective GDPs.” 

The serious governance reforms about which European politicians are so fond of speaking could then be put in place to ensure that new debts remain small and that the issuance of Eurobonds is a one-time operation.

Which distasteful option – inflation or Eurobonds – will be less revolting to German taxpayers?  Your guess is as good as mine.  (For what it’s worth, my guess is Eurobonds.) 

But the German taxpayer will have to choose.  He is in a union with Italy.  And there is no way he can get out.

By Barry Eichengreen.

Professor Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.  His latest book is Exorbitant Privilege: “The Rise and Fall of the Dollar“.

Well, here’s some additional reading. I’m not sure if it is to be taken serious or just for laughs…

Mario Draghi, governor of Bank of Italy, made the following conclusion in a speech recently:

“There are favourable factors we can rely on to carry forward the consolidation of the public finances, overcome the emergency now overshadowing the economic outlook, and set Italy on a path towards stable growth. We have the advantage that private sector debt and the country’s overall net foreign debt are both limited. Our banks are sound; they have emerged unscathed from the financial crisis that shook large foreign institutions. We possess fundamental resources that have always characterized the Italians: individual initiative, ability to innovate, willingness to work.”


And here’s some more insight from Mr. Draghi and Bank of Italy:

Related by the EconoTwist’s:


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