Only the ECB can save Italy now, but it can’t act alone
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November 9, 2011
Here we go again. Europe’s debt crisis has entered a new, more dangerous phase with the yield on Italian 10-year bonds crossing the seven per cent level on Wednesday morning.
This is a eurozone-era record that, if sustained, would severely destabilise the debt situation of the world’s third largest bond issuer and one of the original six founders of the modern European project.
Those who lived through the horrid days of the various emerging market debt crises will quickly recognise the four distinct factors that have come together in the last few days to form a highly destabilising cocktail. And they may well agree on what needs to be done to stop a bad situation getting worse.
Messy domestic politics have undermined the already-complicated relations between those with the potential to solve Europe’s debt crisis – the highly-indebted countries, their official creditors and private holders of their debt.
As in Greece, Italy is now going through an uncertain political transition. While the media has understandably focused on when and how Prime Minister Silvio Berlusconi will resign, what Italy urgently needs is much more complex – namely, a new government that can credibly design, implement and shepherd multiyear efforts to lower debt and deficits, while also increasing economic growth.
Secondly, it has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can.
In the last few days several banks have rushed to announce that they have been actively reducing their holdings of Italian debt – as a means of reducing market concerns about their own well-being. This phenomenon is similar to the 1980s phase of “macho provisioning” that saw banks trying to outdo each other in telling the world that they were fully protected against their past loans to Latin America.
The result today is to encourage and push other Italian creditors to also sell, adding to the market pressures. In too many cases, the damage to the demand for Italian bonds is much more than transitory.
Third, a series of technical changes are disrupting the Italian bond market, adding to its instability.
They range from Tuesday night’s increase in margin requirements imposed by a major clearing house, to the decrease in availability of hedging instruments in the derivative markets.
Finally, the European Central Bank has appeared more hesitant in recent days to purchase Italian bonds. Whether it is an issue of willingness or ability, the result has been to add to the mounting market instabilities.
Left to their own devices, several of these factors could get even more disruptive. Italy is now in the grips of what economists call a ‘path-dependent multiple equilibria’ – where one bad outcome raises the probability of another, even worse outcome.
There is only one institution that has an immediately-available balance sheet that could stabilise the situation in the next few days and weeks – the ECB. But before we all join the chorus urging the bank to do more, we should recognise that it, alone, cannot deliver good outcomes.
To act as a durable circuit breaker, the ECB needs others to help on four critical issues: a bold and lasting separation in how we deal with Europe’s insolvent nations and its illiquid ones; a regional programme to enhance growth and employment; immediate actions to counter the fragility of the banking system; and bold political decisions to strengthen the institutional underpinning of the eurozone, either as it is configured today or via a smaller and less imperfect one.
The European summit on October 23 came close to partially addressing some of these factors but slow progress and disruptive national political developments limited its impact. As a result, Europe’s crisis has entered a new and even more worrisome phase.
With neither the region nor the global economy in a position to afford many more slippages, let us hope that this latest development will serve as a loud, urgent and effective call for proper diagnosis and comprehensive action.
The writer is the chief executive and co-chief investment officer of Pimco
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