Disclaimer: These last three pieces on the impact of Italy’s potential insolvency on the sovereign debt crisis are not advocacy pieces. They are analysis – predictions of what I see as likely to occur.
Yesterday I wrote why questioning Italy’s solvency leads inevitably to monetisation. The long and short of it is that Italy is too big to fail. Too many undercapitalised European banks own lots of Italian sovereign government bonds for Italy to default without causing a major panic and a run on euro zone banks, massive bank failures and a major Depression. Even if the German, French, Dutch or Austrian governments were to step in and try to recapitalise their banks after an Italian default, I am not sure they could prevent a bank run. Moreover, German, French, Dutch and Austrian sovereign credit ratings would suffer considerable damage and questioning their solvency would begin as well. That’s what it means to have no currency sovereignty and no lender of last resort. This affects every nation within the euro zone.
I also wrote in conjunction with Friday’s video clip from RT “how I would provide the backstop”. The ECB would ‘guarantee’ a rate for Italian bonds that is high enough to be a penalty spread to Bunds – liquidity at a penalty rate – say 200 bps to German Bunds, which would be 3.8% on 10-year money. The ECB would not necessarily have to buy any BTPs to defend its target. The private sector “would do it” for the ECB via the language and confidence in the “guarantee”. That’s how it works at the short end of the curve with the policy rate by the way and it is also exactly what the Fed did during the 1940s and 1950s; so we know ‘financial repression’ works. After an initial foray in the market to prove the credibility of the backstop and to ‘punish’ speculators, every speculator would blanch at going up against the ECB’s wall of liquidity for fear of insolvency. I added the part about speculators because that’s how policy makers in Europe think about this crisis.
The point is that this is a moral hazard. The only way to credibly force countries within the euro zone to get onboard with fiscal tightening is fiscal integration. That’s why a future rump Euro will have it or be comprised of more similar national economies. In the absence of fiscal integration, you have these makeshift policies of moral suasion and empty threats. In Ireland, Portugal and Greece’s cases, the threats are more real because those economies are small. The ECB would not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece, Portugal or Ireland. However, Italy and Spain are too large to believe this threat is credible.
Now I don’t really think anyone who has run through the financial sector balances would claim fiscal integration or fiscal tightening is in the interest of Germany’s mercantilist trade policy since the euro zone is one giant vendor financing scheme. If the periphery tightens fiscally, this is unlikely to significantly reduce net savings in the private sector and is therefore, likely to have a big negative impact on German exports and economic growth. But what choice does the euro zone have. Either accept the fact that Germany must finance the periphery in order to sell their wares there or face shrinking export demand and economic growth. This is exactly the same dynamic we see between the US and China. Michael Pettis called it the “Dilemma over current account vendor financing”.
To sum up, the euro zone is in an existential crisis, brought on by fiscal, private sector and current account, imbalances in a fixed exchange rate environment lacking a lender of last resort. The morality of the economics of this situation are only relevant in regard to the economic nationalism to which these kinds of morality plays give rise. On the other hand, this arrangement necessarily means that some countries within the fixed exchange rate imbalance will eventually suffer a sovereign debt crisis due to the imbalances. Without a lender of last resort, such a crisis becomes existential as default is inevitable without at least an implicit backstop from the central bank. And sovereign default would inflict huge losses on sovereign creditors, cascading the insolvency down the line to the banks.
My conclusion: the ECB will backstop Italian (and Spanish) debt. What that means for Portugal, Ireland, and Greece, I don’t know.
The likely impact of this kind of action is an increase in expected nominal GDP in the euro area. If these expectations don’t include an increase in future real GDP within the euro area, monetisation would lead to a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So, in that case, this could be considered a beggar thy neighbour economic policy – competitive currency devaluation, if you will. It may invite reactions from the US and other currency areas.
Is this kind of monetisation sustainable over the medium-term? 100%.
If a central bank guarantees investors credibly that they can invest in certain debt instruments and not suffer principal or interest repayment risk, but only currency and inflation risk, some investors are almost definitely going to buy the debt instruments with the greatest yield pick up. Put another way, the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.
I should add that that is exactly why investors were in these bonds in the first place. It was only when the solvency issue came to a head that yields began to climb. Investors believed in convergence. They believed that Portugal, Ireland, Italy, Greece and Spain all had implicit backstops just as they believed Fannie Mae and Freddie Mac had them in the United States. In the US case, investors were right.
Does the ECB want to lose its trump card in dealing with Italy? No. That’s why they aren’t offering an explicit backstop. But if they don’t backstop Italy, Italian yields will remain elevated, Italy will default, all of the German and French banks with those bonds will be insolvent, and we will have a Depression. Italy is too big to fail.
If the ECB does backstop Italy credibly and fully, then yields will fall and investors will pile in again. However, this is nothing more than a temporary patch, a medium-term liquidity solution only. Clearly, the issue for the Dutch and the Germans is that Italy would have no reason under this arrangement to make reforms or move to fiscal consolidation. They fear Italy (and Portugal and Greece) would become permanent ‘free riders’, mooching off of Germany and the Netherlands’ fiscal probity, making the euro a weak currency. The right way to deal with that fear is to choose between greater fiscal integration or breaking the eurozone up at some point in the medium-term (say 2-5 years).
My conclusion: the ECB will eventually move to a lender of last resort role, one that the Bundesbank had for Germany and the Bank of Italy had for Italy before the euro’s introduction. The question is how much damage will be done before they do so.
Europe is already in a double dip recession and the sovereign debt crisis has already moved from Greece to Portugal to Ireland to Spain and now to Italy. Belgium, with its lack of a permanent government and 100% sovereign debt to GDP is next on this list. They would be followed by France and its implicit guarantee for a poorly capitalised banking system and Austria and its implicit guarantee for a banking system highly leveraged to central and eastern European debtors. Eventually, every country will feel the impact because a fixed exchange rate system with no lender of last resort is inherently unstable unless you have fiscal integration and/or compatibility.
The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.
However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.
This post originally appeared at Credit Writedowns and is reproduced with permission.