November 10, 2011

Why Italy’s days in the eurozone may be numbered
Nouriel Roubini

With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of €1,900bn. That would partially address its “stock problem of large and unsustainable debt but it would not resolve its “flowproblem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes timeusually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

One is urgently needed now. Eurobonds are out of the question as Germany is against them and they would require a change in treaties that would take years to approve. Quadrupling the eurozone bailout fund from €440bn to €2,000bn is a political non-starter in Germany and the “core countries. The European Central Bank could do the dirty job of backstopping Italy and Spain, but it does not want to do it as it would take a huge credit risk. It also cannot do it, as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause.

Thus, since half of the European financial stability facility’s resources are already committed to Greece, Ireland, Portugal and to their banks, there is only about €200bn left for Italy and Spain. Attempts have been made to use financial engineering to turn this small sum into €2,000bn. But the leveraged EFSF is a turkey that will not fly, because the original EFSF was already a giant collateralised debt obligation, where a bunch of dodgy, sub-triple-A sovereigns try to achieve, by miracle, a triple-A rating via bilateral guarantees. So a leveraged EFSF is a giant CDO squared that will not work and will not reduce spreads to sustainable levels. The other turkeyconcocted by the EFSF was supposed to be a special purpose vehicle where reserves of central banks become the equity tranche that allows sovereign wealth funds and the Bric countries to inject resources in a triple-A super senior tranche. Does this sound like a giant sub-prime CDO scam? Yes, it does. This is why it was vetoed by the Bundesbank.

So, since the levered EFSF and the EFSF SPV will not fly – and there is not enough International Monetary Fund money to rescue Italy and/or Spain – the spreads for Italian debt have reached a point of no return.

After a patchwork of lending facilities are cobbled together, and found wanting by the markets, the only option will be a coercive but orderly restructuring of the country’s debt. Even a change in Italian government to a coalition headed by a respected technocrat will not change the fundamental problem – that spreads have reached a tipping point, that output is free-falling and that, given a debt to GDP ratio of 120 per cent, Italy needs a primary surplus of over 5 per cent of GDP just to prevent its debt from blowing up.

Output now is in a vicious free fall. More austerity and reforms – that are necessary for medium-term sustainability – will make this recession worse. Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable.

Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts.

The eurozone can survive with the debt restructuring and exit of a small country such as Greece or Portugal. But if Italy and/or Spain were to restructure and exit this would effectively be a break-up of the currency union. Unfortunately this slow-motion train wreck is now increasingly likely.

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.

The writer is chairman of Roubini Global Economics, professor at the Stern School at New York University and co-author of ‘Crisis Economics’


NOVEMBER 9, 2011

Europe's Entitlement Reckoning

From Greece to Italy to France, the welfare state is in crisis.

In the European economic crisis, all roads lead through Rome. The markets have raised the price of financing Italy's mammoth debt to new highs, and on Tuesday Silvio Berlusconi became the second euro-zone prime minister, after Greece's George Papandreou, to resign this week. His departure may keep the world's eighth largest economy solvent for the time being, but it hardly addresses the root of the problem.

In Italy, as in Greece, Spain and Portugal and eventually France, the welfare-entitlement state has hit a wall. Successive governments on the Continent, right and left, have financed generous entitlements with high taxes and towering piles of debt. Their economies have failed to grow fast enough to keep up, and last year the money started to run out. The reckoning has arrived.

If the first step in curing an addiction is to acknowledge it, there is little sign of that in Europe. The solutions on offer are to spend still more money, to have the Germans bail out everybody else, or to ditch the euro so bankrupt countries can again devalue their own currencies. France's latest debt solution includes raising corporate, capitals gains and sales taxes.

Yet Europe's problem isn't the euro. If it were, Hungary, Iceland and Latvianone of which use the euro—would have been spared their painful days of reckoning. The same applies for Britain. Europe is in a debt spiral brought about by spendthrift, overweening and inefficient governments.

This is a crisis of the welfare state, and Italy is a model basket case. Mario Monti, who is tipped to lead a new government of technocrats, once described the Italian economy as a case of "self-inflicted strangulation." Government debt is 120% of GDP, making Italy the world's third largest borrower after the U.S. and Japan. Its economy last grew at more than 2% a year in 2000.

An aging and shrinking population is a symptom, but not a leading cause, of the eurosclerosis. A fifth of Italy's 60 million people are 65 or older and make increasingly expensive claims on state-paid pensions and other benefits. In fast-growing Turkey, only 6.3% fit that demographic. Italian women have on average 1.2 children, putting the country's birth rate at 207th out of 221 countries.

But the bulk of the responsibility lies with politicians. Mr. Berlusconi, Italy's richest man, promised a shake up each time he ran for office (in 1994, 1996, 2001, 2006 and 2008). He was the longest serving premier in post-war Italy, from 2001 to 2006, controlled parliament and could have pushed through reforms. He didn't. Promises to lower taxes and hack away at regulations and protections for Italy's powerful guilds—from taxi drivers to pharmacists to journalists—were broken.

"It is not difficult to rule Italy," Benito Mussolini once said, "it is useless." The so-called concertazione, or concert, of Italian coalition politics that brings together numerous parties in the Parliament makes for unstable and indecisive governments. So does the fear prominent in many European countries that any serious reform will provoke street protests. An unhappy byproduct of a welfare state is that it creates powerful interests that will fight to the last to preserve their free lunch, no matter the cost to the country.
But now hard choices can no longer be postponed. And the solution to Europe's debt crisis must begin with reforming, if not dismantling, the welfare state. Europe rose from the economic grave in the 1960s, it rode the Reagan-Thatcher reform wave to more modest growth in the 1980s-'90s, and it can grow again. A decade ago, Germany was called the "sick man of Europe," bedeviled by Italian-like economic problems. But a center-left coalition, supported by trade unions and German society, overhauled labor and welfare codes and set the stage for the current (if still modest) export-led revival in Germany.
The road from Rome may now lead to Paris, Madrid and other debt-ridden European countries. But this is no cause for U.S. chortling, because that same road also leads to Sacramento, Albany and Washington. America's federal debt was 35.7% of GDP in 2007, but it was 61.3% last year and is rising on an Italian trajectory. The lesson of Italy, and most of the rest of Europe, is never to become a high-tax, slow-growth entitlement state, because the inevitable reckoning is nasty, brutish and not short.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

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 competitivenesswitness 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?
The writer is an FT columnist
Copyright The Financial Times Limited 2011


Déficit y recesión

España debe cumplir con el Pacto de Estabilidad, pero Europa debe pensar en ajustes más suaves


El Gobierno ha ratificado con contundencia que España no renuncia a cumplir los objetivos de déficit fijados en el pacto con sus socios europeos. La vicepresidenta Elena Salgado ha sido la encargada de recordar el compromiso de estabilidad presupuestaria, que obliga a reducir el déficit al 6% este año, al 4,4% en 2012 y al 3% en 2013, en respuesta a la propuesta del candidato a la Presidencia, Alfredo Pérez Rubalcaba, de que se aplace en dos años el objetivo del 3%. Un Gobierno sensato no puede ni debe sostener públicamente que se desdice del Pacto de Estabilidad, porque sufriría nuevas presiones en el mercado de la deuda; y hace tiempo que el Gobierno español decidió que la solvencia del Reino de España es el objetivo prioritario.

Pero la respuesta oficial de Economía no excluye tajantemente la posibilidad de que puedan cambiar las condiciones del ajuste español. "Si en alguno de estos años los requisitos de la UE son diferentes, nos acomodaremos a los nuevos requisitos", asegura la vicepresidenta. Es decir, corresponde a las instituciones europeas proponer una flexibilización de los compromisos de déficit, si cambian las circunstancias; porque solo si la iniciativa surge de Europa podrá evitarse una nueva tormenta financiera sobre países como Italia o España.

Pero el caso es que la Comisión, Alemania y el BCE no pueden evitar que se extienda el debate sobre la conveniencia y eficacia de las políticas de ajuste estricto que se han impuesto a los países rescatados (Grecia, Irlanda y Portugal) y a otros como España que han aceptado un calendario de estabilidad para evitar el rescate. A primera vista, podría decirse que los programas de contracción fiscal han obtenido un resultado mediocre. No han conseguido siquiera que todos los países sujetos a rescate reduzcan el déficit en los términos acordados y han procurado estabilidades precarias para las deudas portuguesa o irlandesa.

Pero el daño mayor se produce cuando las políticas de austeridad extrema son incompatibles con políticas que permitan estimular la demanda, combatir la recesión y facilitar el crecimiento. Las contracciones fiscales estrictas, sobre todo cuando se aplican en todos o la mayoría de los países de un área económica, terminan aumentando el desempleo y sumen a las economías en una espiral de depresión de la demanda, más paro y recesión ininterrumpida.

El caso de España es un buen ejemplo de las trampas que puede contener el ajuste. La recesión que se avecina reclama políticas de estímulo, que no se pueden aplicar si los recursos públicos están totalmente esterilizados por las exigencias de reducir el déficit a toda prisa y a cualquier precio. No se trata de incumplir los compromisos de estabilidad, sino de que Europa proponga, en el momento adecuado en que no afecte a los mercados, un calendario más razonable de cumplimiento. Un nuevo pacto que haga posible controlar el déficit y, al mismo tiempo, disponer de la inversión suficiente para incentivar el crecimiento.

November 9, 2011 6:54 pm

What happens next? The scenarios for Italy

Italian Prime Minister Berlusconi holds League North Party leader Bossi's hand during a finances vote

Markets have pushed Italy and the eurozone towards what many investors see as a tipping point, but European Union officials on Wednesday said they were waiting for Italy to decide on a new government rather than planning emergency measures to turn the tide.

The decision to stand firm appeared both a measure of the eurozone’s continued belief that only Italy itself can now change market sentiment – and a tacit acknowledgement the tools in the international arsenal have become increasingly limited.

10 year bondsClick to enlarge

.The prospect of a technocratic government taking over quickly from a teetering Silvio Berlusconi to push through long-demanded economic reforms – coupled with returning order to Greece and beefing up their €440bn rescue fund – presented the best hope for turning around a darkening crisis.

“There is nothing that the European [leaders] can effectively do at this point,” said Sony Kapoor, head of the economic consultancy Re-Define. “They have to let events happen in Italy.”

But if current plans do not work, the scenarios quickly become far more complicated:

1. The current plan: cut debt and spur growth now
EU officials and the majority of independent analysts agree that Italy’s economic fundamentals, while not rosy, are far better than those of Greece or other eurozone countries in full-scale bail-outs. Italy’s debt levels are high, but its annual deficits are small, its banking sector is sound, and its overall economy big and diversified.

As a result, reforms that can immediately cut the country’s debt burden and spur economic growth could have a powerful effect on its ability to dig out of the current hole. Making sure Italy moves forward on plans to do both is the reason officials pushed Rome to accept both EU and International Monetary Fund monitors.

Mujtaba Rahman, an analyst at the Eurasia Group, said the Italian panic had been made worse by Greece and fights over reforming the rescue fund, the European financial stability facility. Focusing on addressing those pieces may be enough to massage sentiment in the right direction ... in combination with more technical oversight from the IMF to address Italy’s internal issues.”.

A letter sent by EU inspectors ahead of their arrival Wednesday, and obtained by the Financial Times, shows their mission intends to be intrusive. Brussels is asking for a specific list of state-owned assets Rome can sell in order to raise €5bn per year for debt reduction. The letter also asks for measuresover and above” the privatisation plan.

Potentially more contentious, inspectors wrote that they believe Italy would no longer hit budget targets for 2012 and 2013 and asked for Rome to come up with “additional measures” to balance its budget by 2013.

EU officials have reason to hope such measures can work. Ireland, which had solid economic fundamentals before a banking crisis dragged it into a €85bn bail-out last year, has seen its bond yields cut almost in half – from above 14 per cent in July to close to 7.6 per cent earlier this weekafter two quarters of better-than-expected export growth.
2. Provide a precautionary line of credit
This was offered to Mr Berlusconi at the Group of 20 summit in Cannes last week, but was turned down. Such a line of credit would likely come from the IMF, something it does with regularity for countries that are solvent but struggling to raise cash. Last month, the EFSF was given similar powers and there is now talk it could step into the breach.

Essentially, the EFSF or IMF would give Italy a limited amount of creditanywhere from €50bn to €80bn – with a firm set of conditions attached. Doing so would lend credibility to the Italian reform plan and solve the most immediate problem: Italy’s inability to borrow money at sustainable rates.

But the move could further spook investors, convincing them Italy’s problems were worse than originally believed. In addition, even at eye-popping levels, the aid may not be enough. Italy must raise €300bn next year. “That €50bn will get used up in three months or so,” said Mr Kapoor. “Then what?”
3. If all else fails: a full-scale bail-out

If Italy proves unable to return to the public markets with a credit line, the next step would be a bail-out that would take Rome out of the bond market altogether.

If such a plan were to follow previous models, it would be a three-year programme where EU and IMF lenders would carry the weight of Italian debt payments until confidence returned so Italy could service its own debts.

The problem is Italy’s size. While a small country like Greece needs about €130bn to cover borrowing needs for three years, Italy would need that much to cover just six months.

All told, the EFSF, which started with €440bn, now only has about €250bn left to lend – a number that in an Italian bail-out suddenly gets cut to €110bn, since Italy contributes €139bn to the fund.

Italy would therefore have to rely heavily on the IMF. But IMF officials said they only had about $400bn on hand – or about €300bnbarely enough to last Italy through next year. Developing countries such as Brazil would undoubtedly object if the IMF dedicated that much money to another eurozone rescue.
4. Or, a takeover by the European Central Bank
Some eurozone governments, led by France, have argued that the ECB must become the zone’s lender of last resort in order to stop the run on peripheral sovereign bonds. If it were to guarantee all Italian debt, the ECB’s unlimited firepower – it can literally print money – could give it the power to buy every Italian bond and ensure Rome could borrow at low rates for the foreseeable future.

Central banks in the US and Britain already do this routinely. But Germany has long objected to so-calledmonetary financing” – using central banks to fund government spending – and ensured it was prohibited in the Lisbon Treaty, which governs EU institutions.

Leading voices in Berlin, including the German president, have already objected to limited ECB bond purchases, and there has been no sign Berlin would back down. But because Germany has only two votes on the ECB board, German opposition could be overcome.

“You could end up with a divided ECB with the majority saying we’re facing an existential crisis,” said Mr Kapoor.

But some worry that even the bottomless pockets of the ECB may not be enough to stop the panic if it were to grip the €1,900bn Italian bond market by the throat.

“The situation has deteriorated so dramatically a large-scale asset buying by the ECB would not necessarily be a panacea,” RBS analyst Alberto Gallo said in a conference call with investors on Wednesday. “I do not think the ECB on its own could bring back the market to the point before Italy succumbed.”
Additional reporting by Rachel Sanderson in Milan

Copyright The Financial Times Limited 2011.