July 12, 2011 6:46 pm
The battle plan for the eurozone debt market has been to ringfence the smaller peripheral countries to avoid contagion to Spain – and its further spread from there, in the nightmare scenario. Events have now blown that battle plan out of the water. Panicked markets, it turns out, see no need for an Iberian stopover before a direct attack on Italy – the single currency’s third-largest economy with its second heaviest public debt burden. The crisis has suddenly turned a whole lot scarier – but not yet scary enough to shake Europe’s leaders out of their complacency.
Up until Monday, Italy’s cost of borrowing were soaring. Spreads over German bunds reached 3 percentage points, a euro-era record, before coming down a little. Investors across all markets took fright; none more than shareholders of Italian banks, whose equity values plunged by as much as a third.
Markets’ nerves were already frayed by still-inconclusive debates on how to solve Greece’s financing problem. But Italy is not just a victim of market contagion, in spite of a reputation for relative fiscal probity. It was the height of irresponsibility to sow doubt on the passage of an austerity budget, let alone to make it hostage to prime minister Silvio Berlusconi’s business interests.
Rome’s blame for where it now finds itself has a long pedigree. It is true that its deficit is smaller than most of its partners’, and was admirably controlled during the crisis. But under Mr Berlusconi, Italy eroded a primary surplus which reached 5.5 per cent of gross domestic product in 2000. Like peripheral states now at the mercy of external aid, Italy wasted the windfall from low interest rates in the euro’s first decade without creating sustainable growth.
As a result, the debt-to-GDP ratio never fell below 100 per cent and is now about 120. That makes for an explosive debt dynamic: any rise in sovereign yields is amplified in its effect on interest costs. The sustainability of the debt is correspondingly precarious: if buyers of Italian government debt demand a higher risk premium, a vicious spiral could easily be set off.
This outcome can yet be avoided; it would in any case unfold gradually as Rome refinances its debt over time. But there is no excuse for postponing what needs to be done: the austerity budget must be passed now. This has a chance of calming markets. Their worries about Italy may still be mostly derivative: self-fulfilling fears of contagion from Greece. It is in Italy’s – and all of Europe’s – vital interest that markets not lose confidence in Rome in its own right.
That still leaves the Greek situation unsolved. The signs are not good: in a testament to their complacency, some leaders doubt that a solution can be put in place until parliaments return from summer breaks. At least the Italian scare has put back on the table policies that had been wrongly discarded. Chief among these are voluntary buy-backs designed to capture the market discount to reduce Athens’ debt burden. The Financial Times advocates a Brady plan by which investors would swap Greek bonds into new ones that lighten the payment schedule but enjoy eurozone-guaranteed collateral.
The mechanics matter, but what matters most is the principle. The eurozone must explicitly commit to what it still dares not tell voters: it is moving toward guarantees on the periphery’s entire public debt. This price must be paid to get markets started again. In return it is possible to capture, for taxpayers’ benefit, the discounts already implicit in market prices – a true private sector participation. With the incentive of collateral, the devastating consequences of forced haircuts could be avoided.
Banks and several capitals are warming to such solutions. Resistance remains – most crucially in Berlin. It must be overcome: history does not look kindly on those who fiddle while Rome burns.
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