Eurozone Leaders Fiddling as Rome Starts to Burn?

Worries about the Eurozone have heretofore been depicted as afflicting the periphery. But even though Italy is geographically on the margin, if the crisis engulfs it, it irreparably damages the core. And that time seems to be upon us.

European leaders have managed to muscle their way through an existential crisis with eleventh hour patch-up remedies that have worked for as little as days and sometimes as long as months. But the spectacle of the Greek rescue being retraded while in progress (Greece was told to take an austerity bullet to prevent default for now, but insufficient take-up of the debt rollover, an outcome that was clearly widely known, since it was discussed in the Financial Times, has led the powers that be to deal with nasty realities and consider the “D” word, for at least some of the bonds. That in turn led to a market freakout which continues today.

Ambrose Evans-Pritchard of the Telegraph explains why this escalation of the crisis looks so dire:
Yields on Italian 10-year bonds hit a post-EMU high of 5.3pc on Friday. This is not just a theoretical price: the Italian treasury has to roll over €69bn (£61bn) in August and September; it must tap the markets for €500bn before the end of 2013. The interest burden on Italy’s €1.84 trillion stock of public debt is about to rise very fast.

Spanish yields punched even higher, through the danger line of 5.7pc. The bond markets of both countries are replicating the pattern seen in Greece, Portugal, and Ireland before each spiraled into insolvency. And the virus is moving up the European map. French banks alone have $472bn (£394bn) of exposure to Italy and $175bn to Spain, according to the Bank for International Settlements.

European stocks are down in a serious way, and the euro continues its swan dive and S&P futures are trading down 14 points, a recovery from down 20 about an hour ago. From the Wall Street Journal:

European stocks opened sharply lower Tuesday and the euro remained under pressure, as investors continued to fret that the region’s debt crisis is spreading to Italy.

The Stoxx Europe 600 Index opened down 0.6%. Frankfurt’s DAX and Paris’s CAC-40 Index both dropped 1.7%, while London’s FTSE 100—less exposed to the euro-zone crisis than its continental peers—slipped 0.3%. The Milan market opened 2% lower.

Italian banks were among the heaviest fallers in early trade, amid concerns about their exposure to sovereign debt and fears some may not pass upcoming stress tests. Intesa Sanpaolo SpA fell 5.7% in Milan, while UniCredit SpA lost 7.1% before its shares were suspended from trading. Banca Monte dei Paschi di Siena SpA dropped 3.9%.

Fears that Italy may be the next country to be embroiled in a debt crisis, together with comments from International Monetary Fund Managing Director Christine Lagarde on Monday that it was too early to discuss a second Greek bailout, sent the euro to a four-month low against the dollar at $1.3932.

Those opening quotes understate the degree of deterioration. The FTSE is now down 1.7%, the DAX 2.3% and the
The latest reading from Bloomberg describes how the specter of European leaders casting about for new remedies is failing to reassure investors:

European finance chiefs cast about for a strategy to halt Greece’s debt spiral, reviving previously discarded ideas and sharpening a dispute with central bankers as the rot spread to Italy.

As exploding bond yields in Italy and Spain brought the crisis closer to the heart of the euro area, Europe’s search for answers took it back to a proposal scuttled by Germany this year to buy back discounted debt. Also being considered are remedies that would put Greece into temporary default, countering pleas from the European Central Bank to avoid that step at all costs.

The brainstorming in Brussels failed to stem the plunge in European shares and bonds of the most-debt laden countries, reflecting investor concern that their efforts will be overwhelmed. The euro fell to its weakest in four months. Italy’s 10-year bond yields exceeded 6 percent, reaching the highest since 1997. Milan’s stock index fell to its lowest in more than two years.
“They are misjudging the size of the problem they face,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland Plc. “This is a euro-wide crisis and again they are behind the curve.”

Nine hours of talks yesterday yielded a six-paragraph statement in which the 17 euro governments pledged to flesh out a new master plan “shortly” to end the 21-month-old crisis, without setting a timeline. The meetings resumed today with all 27 EU finance ministers plotting a response to the release of bank stress tests later this week.

And to make matters worse, Berlusconi has decided to oust his well-respected finance minister at the worst possible juncture. David Malone explains (hat tip reader Jeremy) why this is key to the crisis is spreading from Greece to Italy without impairing Portugal and Spain first, as expected:

First let’s remember that Mr Tremonti is Italy’s answer to America’s Greenspan. He has governed Italy with Berlusconi for 15 of the last 17 years and spent many of them as finance minister. During that time Italy’s debt has climbed to about 120% of GDP and over 2 trillion euros. Right or wrong people see Tremonti as the man who has protected Italy and her banks. They fear that without him something bad will happen. I think they’re right. Without him some bad things will surface….

This is the logic that I think explains why the market sells UniCredit like it has the plague at the slightest hint of trouble. I think the market knows or at least suspects that UniCredit is in very bad shape and will only survive for as long as it’s [sic] friends have total control over Italian regional and National politics. Should Tremonti, in particular, lose his grip, then UniCredit’s viability suddenly looks very fragile indeed.

And if UniCredit looks fragile then so does Italy as a whole. UniCredit’s fall would bring Italy down, gold reserves or no gold reserves.

In my opinion Italy as well as UniCredit is in far, far worse shape than has so far been admitted. Italy has, I think, hidden debts in its Cities and regions, particularly those of the North. I think we will see ‘new’ debts surfacing, particularly if Berlusconi and or Tremonti goes.

But as Evans-Pritchard reminds readers, the real issues go much deeper:

More loan packages solve nothing. Pretending that this is just a liquidity crisis will no longer wash….Germany must now be willing either to buy or guarantee Spanish and Italian debt, and in doing so to cross the Rubicon to fiscal and political union, or accept that EMU must break up with calamitous consequences for German foreign policy. Large matters, beyond the intellectual vision of Germany’s current leaders.

It will also take a total purge of the ECB’s leadership, which clings to its madcap doctrine that monetary policy can be separated from other emergency operations, and which chose last week of all moments to raise interest rates again and kick Spain in the teeth. It did so knowing that the one-year Euribor rate used to price more than 90pc of Spanish mortgages must rise in lock-step.

And he rejects the rationale for the rate increases:

Where is the inflation threat? The eurozone’s M1 money supply has contracted on a month-to-month basis over the past two months, with sharper declines in the periphery. Annualized M1 growth is falling, not rising: it was 2.9pc in March, 1.6pc in April, and 1.2pc in May. Broader M3 grew at a rate of 2.2pc over the past three months.

The PMI data for Italy and Spain have dropped below the recession line. The Goldman Sachs global PMI indicator shows that 80pc of the world is tipping into a slowdown, including India and China. Taiwan’s bell-weather exports to China sank 12pc in June from the month before.

The blind dedication to austerity is not just driving countries like Ireland and Greece over the cliff but now about to take the Eurozone project along with it. There is a big difference between a severe, painful but relatively short-term dislocation of writing down bad debt and imposing losses on bondholder by forcing haircuts or equity conversions on them and the grinding process of deflation. The latter doesn’t simply destroy wealth; it has the potential to fracture the social order. Yet political leaders, addicted to expediency, are playing a far higher stakes game than they seem willing to comprehend.

Update 6:00 AM: Mirabile dictu, someone seems to have floated a rumor that is making Mr. Market a tad less anxious. Per Clusterstock:

Remarkable.

After crashing 4% earlier, the FTSE MIB index is back to being flat on the day, following talk of the ECB stepping into buying bonds.
Still, most markets around the world are getting clubbed, just less than they were earlier.
Italian short-term yields are still higher on the day, though less so than they were earlier (see here).

Spain is off about 0.8%

Germany is down 1.7%.

This post originally appeared at naked capitalism and is reproduced here with permission.