Markets Insight
November 8, 2011 7:40 pm
Eurozone exits and defaults may be only escape
The contagion that has taken Italian government bond yields to euro-era highs sends an unpleasant reminder to eurozone politicians that when it comes to managing sovereign debt crises, perception is all.
Nothing in economic theory or practical analysis can predict when investors will lose confidence in the ability of a government to service its debts. For confidence to return, those same investors have to believe that the rate of economic growth in Italy will exceed the rate of interest on the debt, which implies a reversion to yields close to German levels. Given Italy’s current political mess, it is hardly surprising that the markets are reluctant to give the country the benefit of the doubt.
There are two obvious ways of mitigating the damage. The first is to buy time for Italy and the rest of southern Europe through official purchases of government bonds. The European Central Bank under Jean-Claude Trichet made it clear that it would only engage in bond purchases while holding its nose and on the basis that the purchases would be reversed as soon as possible. The ECB’s new boss Mario Draghi is of the same mind. As Bradford DeLong, of the University of California at Berkeley, remarks, it is difficult to think of a more self-defeating way to implement a bond purchasing programme. If the ECB has consistently demonstrated a lack of confidence in the very bonds it was buying, why should investors feel any differently?
Of course there are reasons for such reluctance, notably the fear of moral hazard. Safety nets encourage loose behaviour. But when the whole eurozone is in peril and the future of the European Union is at stake, it is no time to be quibbling about morally hazardous niceties. That, after all, is why central banking developed the tradition of last resort lending, starting with the Bank of England’s intervention in the financial crisis of 1825-26.
Instead we have the European financial stability facility, a curious off-balance sheet lender of last resort. Despite recent frenetic summitry, the politicians have failed to convince markets that this rescue fund will ever be adequately resourced. Hence the dismal market reception for the EFSF’s €3bn 10-year bond issue on Monday, despite a seemingly generous launch spread.
That leaves the policy route preferred by Messrs Trichet and Draghi, which is for national governments to reform their way out of the crisis. This is necessary anyway, since Italy’s underlying problem, and that of much of southern Europe, is poor competitiveness – witness the Italian economy’s failure to deliver any growth over the past 10 years. Within a monetary union this has to be addressed through internal devaluation via the labour market. In Italy, as in Greece, the expectation is that this task will fall to a technocratic government. What are the chances of success?
Previous technocratic experiments, notably under the prime ministership of Romano Prodi, showed mixed results. And today the economic backdrop is much less favourable. While the government has been running a modest primary budget surplus, the interest on public sector debt leaves an overall deficit of 4.5 per cent of gross domestic product. It will be impossible to reduce the huge debt stock without growth. Yet the Italian economy is already probably contracting and recent eurozone economic data suggest that a wider deterioration is under way.
Structural reform takes time. And whether a technocratic government has the legitimacy necessary to push through really radical reform is moot, especially if the electorate thinks the government is taking dictation from punitive German politicians. It is worth recalling that Italy’s greatest success in managing public debt came not under technocrats but under a strong Fascist regime after the first world war.
Between 1922 and 1926 the government debt to gross domestic product ratio was reduced from 74.8 per cent to 49.7 per cent, while the budget deficit was eliminated. This coincided with the annihilation of all political opposition to Mussolini’s regime. The fiscal medicine also included de facto default in the shape of two forced conversions to extend the maturity of the debt in 1926 and 1934.
If the obvious escape routes are too difficult, something has to give. And it may be, to a greater or lesser extent, the eurozone itself. Ironically, Angela Merkel and Nicolas Sarkozy may have speeded up the process by breaking the taboo about referring to possible exits from the euro. This is the perfect way to encourage destabilising capital flight from southern Europe. Maybe disorderly defaults and exits from the eurozone are the only way to escape from this nightmarish construct, which has such nasty echoes of the interwar period. That would be highly dangerous. But would it be worse than years of deflation and crucifying unemployment all across southern Europe?
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The writer is an FT columnist
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Copyright The Financial Times Limited 2011
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