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Why questioning Italy’s solvency leads inevitably to monetisation

Last week we witnessed a flight to quality within the euro zone government bond market. The yield on 10-year German government bonds dropped a record 35 points last week. German 10-year bonds now yield 1.82 percent. Meanwhile, the yield on 10-year Italian government bonds continues to rise, last quoted by Bloomberg at 6.37%, a record 455 basis points higher than German government bonds.

Clearly, Italy is now the biggest focal point of the European sovereign debt crisis. And, make no bones about, while the immediate concern for Italy is liquidity, at heart the European Sovereign Debt Crisis is a solvency crisis. Let’s take a look at Italy to see why.

The “Complete Strategy”

On October 26th, the EU announced to great fanfare that it had hammered out a “complete strategy” to deal with the ever-widening European sovereign debt crisis. The text of summit statement showed three pillars upon which this strategy rested.

  1. Sustainable public finances and structural reforms for growth: “The European Union must improve its growth and employment outlook, as outlined in the growth agenda agreed by the European Council on 23 October 2011… All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms.”

  2. Stabilisation mechanisms: “We agree on two basic options to leverage the resources of the EFSF: providing credit enhancement to new debt issued by Member States, thus reducing the funding cost…; maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles.”

  3. Banking system package: “There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures… Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”

The first of three pillars addresses solvency of euro area national governments while the second addresses liquidity. The third addresses both the liquidity and solvency of euro area banks. But will this solve Italy’s problems?

Italy

Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.

As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.

How can Italy get out of this trap?

Lower interest rates: The plan presented by the EU was to relieve Italy of its interest rate burden by leveraging the European bailout facility, the EFSF. In order to do this, the Europeans need a “combination of resources from private and public financial institutions and investors”. We know that European banks are undercapitalised and European countries are in the midst of a sovereign debt crisis. So no funds are going to be forthcoming there. The United States is having its own fiscal battles and cannot take the lead. That leaves the biggest developing countries, China, Brazil and India and oil rich sovereigns to bail out the Europeans. The Chinese have already said they are not going to get involved and the amount of resources Europe can get from elsewhere is not nearly enough to backstop Italian government debt, the third largest government debt load in the world unless the Europeans are relying on aliens to fund them. So this pillar of the three-legged stool is broken – at least for an economy the size of Italy’s.

Growth: Given the fact that Italy has one of the lowest ratios of births to deaths in the world, it also has a rapidly aging society, which limits potential economic growth. Even if domestic GDP expands by a wildly optimistic 2 percent per year – it has expanded less than one percent over the last decade – you would need 3% growth from exports in order to stabilise the debt to GDP ratio at 120% at prevailing interest rates. That is never going to happen. So this leg too is bust.

Austerity: The Europeans are pushing Italy to make structural reform. But the Italian government has been unable to make these reforms. Prime Minister Berlusconi priorities seem to be elsewhere and his government is weak; likely the government will collapse. Even so, Italy’s labour minister Maurizio Sacconi warns that rushing through the labour market reforms which the EU demands risks creating the preconditions for a wave of terrorism. Wow. Do you really think, the Italian government, which seemed to have a different governing coalition almost every year for most of the post World War II era, is going to be able to push these kinds of draconian reforms through? And I haven’t even mentioned budget or public pension cuts.

The Italians don’t have a leg to stand on.

Monetisation

This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.

The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.

Now that the credit crisis has moved on to sovereign debt, the central bank can play this role with sovereign debt as well. The best way to accomplish this task would be to start buying enormous quantities of sovereign debt, inducing a huge shift in the price/interest rate of those assets. Only afterwards, the ECB would announce that it was prepared to supply unlimited liquidity to stand behind these assets at specific target interest rates and would do so at the most inconvenient moments for speculators wishing to make a quick euro. (Update: see comments of a similar nature after this was written from Willem Buiter at the bottom.)

The point would be twofold:

  1. Market participants would understand that the ECB had unlimited means to back up threats with action, the stress clearly on the word unlimited.
  2. Market participants would understand that the ECB intended to penalise speculators by targeting them with its unlimited liquidity.

As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.

The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will.

-Three options for the euro zone: monetisation, default, or break-up, Nov 2011

I wrote these paragraphs one year ago and I see nothing that has occurred since then which makes me want to change anything. In fact, the events of the past year make me think this is all the more likely. Italy was not a factor then; it was Spain which was the problem. Italy has the third largest government bond market in the world. In July, I also mentioned that Italy owes German banks 116 Billion euros. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. And as I outlined above, the route to a sustainable solvency path that leads to liquidity for Italy is blocked at every path. Italy will continue to pay a huge premium for its debt. The only way to ensure Italy’s medium-term solvency is to have it borrow in a currency whose creator is credibly committed to creating an unlimited supply of money in order to backstop Italy’s debt if necessary.

At present, the ECB is buying just enough bonds to send a message to Spain and Italy that they need to live up to their austerity quid pro quo or else the ECB will stop buying. The ECB wants to prevent ‘free riders’ from making the euro a weak currency. But, let’s be clear, a currency with “no lender of the last resort” was a ridiculous concept from the start. The crisis we are witnessing now was always going to happen. As much as the ECB resists it now, they have limited choices: monetise or face a global economic collapse. The longer they wait, the worse it will get.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

20 Comments

  1. ChrisBern says:

    Yes, I completely agree–monetisation is almost a sure thing at this point. The question I have is around capital base. Will there be a point when the ECB needs to rather strongly increase its capital base, or will it just become highly leveraged like the U.S. Fed (which I believe is now leveraged something like 55:1)?

    One other thought is whether the ECB would come out and defend bonds of ANY Euro country in this fashion, or just Italy? Because there are other (mainly smaller) countries which are feeling more and more pressure each quarter, e.g. Portugal. I would think the ECB would need to avoid too much favoritism if it indeed monetizes the debt, as a lot of other EZ countries would have a right to say “what about me, why not backstop my bonds?”

    • Amazed says:

      why would the capitalization of a central bank, in its own fiat currency matter if it can print unlimited amounts?
      it could be negative, it could be 5000:1.. who cares, people would not understand that and would not loose confidence in money because of that..

  2. Hans says:

    You are thinking so inside the box.

    First: Berlusconi is the only politician in the free world with power. He has money! Obama has no money.
    Secondly: under Berlusconi Italy was stable as never before. A Prodi bore anyone? A sport car boss to run a country??? You got to be kidding. And Berlusconi is still very much admired by a lot Italians. And never count out Silvio, he may come back when the new PM falters. And falter he will.
    Thirdly: I am baffled that you do not even mention the biggest economic force in Italy, the mafia.

    Italy was always the first contender to leave the EU. Waaaay before the crises. If Italy reverts to the Lira its whole economy would just flourish. Remember the late 70s early 80s? No you don’t. We shopped almost everything in Italy: The then fantastic Fila mountain stuff, climbing boots, jeans, cappuccini that we almost fainted, Apfelstrudel by the ton…

  3. Economics Considered says:

    I am somewhat diffident about being contrarian, but I simply do not see how monetization is really anything more than a temporary patch before it becomes untenable – and in not that long a time frame.

    The key element is akin to moral hazard. If Italy has essentially a guarantee that it can increase its debt at a ‘workable’ interest rate, what incentive does it have to subject itself to any austerity pain whatsoever. I can’t see any incentive. Not only that, but it seems that Italy would instantly get a certainty that the EU would bail them out no matter what – and then proceed to continue deficits and increased debt resulting in a succession of ‘whats’. And this is even before, as is strikingly pointed out, you take into account that their government situation is likely one where any reforms could be undertaken no matter what.

    I just can’t see it working. All it does is postpone the crisis until Italy has managed to build up their debt even more to a completely disastrous level. As with all of the other 13 kick-the-can-down-the-road measures, it only makes things ultimately even worse – MUCH worse.

    Even worse, how does this sit with Greece and Ireland ?? After they have been ground down with austerity measures and exposed to ruinous interest rates even so, how are they going to deal with Italy getting a pain-free ride ?? Would the ECB now back their bonds UNCONDITIONALLY to keep their interest rates down also ? If not, one could easily see a mutiny.

    One thing should be even more crystal clear after Merkel’s and Sarkozy’s immediate stark agitation over the possibility that Greece might refute the bailout as constituted – they are at the complete mercy of blackmail that threatens the EZ. Greece appears to be too weak-willed to call their bluff – but the threat that they might stumble into a rebellion obviously terrified Merkel and Sarcozy. But I have this suspicion that Italy may not lack the will – or simply may be governmentally unable to do anything other than what amounts to the same thing as blackmail. And if they get ‘special’ treatment, Greece for one might summon the courage in anger.

    So, bottom line, I don’t see monetization as being anything more than a short term patch at best – and with a distinct possibility of being a stimulus for complete chaos in relatively short order.

  4. Dave Holden says:

    I agree that monetization is most likely, I have some cognitive dissonance on how this makes a country more “solvent” but I get (I think) your talking short to medium term and in terms of debt rates vs growth.

    The other option of course is a break up of the Euro. The grass roots political driving force for this I think would be more likely to come from a “creditor” nation. One of the interesting things about recent events in Greece was the general populaces preference for staying in the Euro. To some extent I can understand this, I suspect they see it as a source of stability they’re unlikely to get from their own current governing classes.

  5. As I wrote on the RT post after this one:

    If you think about ONE fact, you will realise why monetisation is sustainable over the medium-term. If a central bank guarantees investors CREDIBLY that you can invest in certain debt instruments and NOT suffer principal or interest repayment risk, but only currency and inflation risk, some are going DEFINITELY going to buy the debt instrument with the greatest yield pick up. The ONLY reason not to buy Italian debt at 2 or 300 basis points over Bunds is because they are not credibly backstopped by the ECB. Think about it and you will see that this is true.

    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.

    I should also point out that this is the very same reason people like/liked the GSEs in the US and why they were nationalised with no hit to bondholders. People bought the GSEs because they believed them to be AAA securities backed by the Federal Government and the central bank. And they are!

    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.

    Again, the only way to credibly force Italy to get onboard is fiscal integration. That’s why a future rump Euro will have it or be comprised of more similar national economies.

    • Oldrich says:

      Thanks. I like your insights.

    • David Lazarus says:

      Maybe this is the French-German plan? Get rid of the weak periphery and have a new Euro based around the core nations. Shame that France will not make it into the new euro. They will need hundreds of billions to re-capitalise its banks.

    • Dave Holden says:

      Yes I wasn’t really thinking about willingness of investors to buy debt post ECB backstopping more the fundamental point that back stopping in the way the ECB is doing at the moment is just taking over the role the market had. Italy would not have to face the discipline of the market but they will have to face the discipline of the ECB. The point being the long term solvency requires a step change in politics, culture and mind set from a country.

      You particular point on the willingness of some investors to keep investing if there is such a back stop is well taken particularly since currency risk in this case is spread amongst 17 nations.

  6. Jim says:

    Edward,

    One question. If you’re right and monetization finally happens in a huge way by the ECB, well….what’s the end game to that?

    If history is any guide, debt monetization typically doesn’t have a happy ending, either. Will the ECB just print trillions of Euro’s for years/decades to come for member countries who can’t borrow money on the open market at low interest rates?

    • Amazed says:

      If you are in a mess, there is no happy ending, just choosing between different bad ends, the least painful one in general.. when politicans decide though, they dont care about the least painful, but the one further down the road, which generally is the worst.. but thats our world..

      • David Lazarus says:

        The public would probably opt for the quick method so at least the uncertainty ends, and they can plan for the future. The politicians hate it because that is their legacy and they will try and avoid it if possible. So extend and pretend is policy even though it is doomed from the start.

  7. Nathan Tankus says:

    the Euro has created a Mercantilist mini-world. As in the Mercantilist era, the countries who lowered their general costs of production by keeping unemployment low, protecting industry, investing heavily in internal improvements and restraining rentier excess in the domestic sector developed current account surpluses that helped compound their success. Those who didn’t found their general costs rise, their society polarize, and when their bubble induced booms popped, they found themselves in a balance of payments crisis. If these countries don’t enter this brave new world (or more accurately, ancient) of currencies completely detached from commodities, their only other option is to act like the high cost developing countries before them. Namely, Britain, The United states, Germany and Japan. they need to protect industry, restrain rentiers, erect tariffs and redevelop a high wage, high skill labor force (which they are rapidly losing to emigration.