November 09, 2011
The Guardian Unlimited, November 9, 2011
Some of us have been warning for months about the crisis scenario that is accelerating today in Europe. In particular I have noted that the European authorities were pushing Italy down a dangerous path, similarly to what they did to Greece. The formula is deadly: force budget tightening on an economy that is already shrinking or on the edge of recession. This shrinks the economy further, causing government revenue to fall and making further tightening necessary to meet the target budget deficit. The government’s borrowing costs rise because markets see where this is going. This makes it even more difficult to meet the targets, and the whole mess can spiral out of control.
Today financial markets reacted violently to this process in Italy, with yields on both 10-year and 2-year Italian government bonds soaring past 7 percent. Let’s do the math.
One year ago, Italy could borrow at 4 percent for 10-year bonds. Today these yields went as high as 7.7 percent. Multiply this difference, 3.7 percent, times the 356 billion euros ($491 billion) that Italy has to refinance over the next year. That’s 13.2 billion euros ($18.2 billion) in additional borrowing costs, or about 1 percent of Italy’s GDP.
Italy has agreed to deficit reduction of 3.9 percent of GDP by 2013, with about 1.7 percent of it coming over the next year. Prime Minister Silvio Berlusconi has just announced he will resign, in part because of the political difficulty of making these changes in a weak economy. Now add another 1 percent of GDP to make the same target – and that the target will move because the economy will likely shrink further – and you can imagine that Italy is not going to make these targets, which is what the bond markets are imagining right now.
In fact, the bond traders can be more imaginative than that. They have noticed that when Portugal and Ireland’s bond yields went above 7 percent, they quickly soared into the double digits. These governments were then forced to borrow from the IMF and the European authorities instead of relying on financial markets.
The European authorities are not prepared to deal with such a situation. Italy is the world’s eighth largest economy, and its $2.6 trillion debt is much more than that of Ireland, Portugal, Greece and even Spain combined. Clearing houses in Europe have recently begun to require more collateral for Italian debt, which has also unnerved markets. A lot of Italy’s debt is held by European banks, and the fall in Italy’s bond prices also causes problems for their balance sheets, increasing the risk of a worsening financial crisis that is already slowing the world economy.
What can be done about this? The European Central Bank (ECB) reportedly intervened heavily in the Italian bond market, and its purchases are probably what brought Italy’s bond yields down somewhat from their peaks. But this is not nearly enough to resolve the crisis.
The ECB is the main problem. It is run by people who hold extremist views about the responsibility of central banks and governments in situations of crisis and recession. Even as facts contradict them on a daily basis, they cling stubbornly to the view that further budget tightening will restore the confidence of financial markets and resolve the crisis.
Governments must take “radical measures to consolidate public finances,” said ECB Executive Board member Jurgen Stark yesterday.
But of course these measures will only pour more fuel on the fire, by pushing Europe further toward recession and exacerbating the debt and budget problems of the weaker eurozone economies.
And the new head of the ECB, Mario Draghi, just a week ago dismissed the idea of the central bank playing the role of lender of last resort – a traditional role for central banks.
ECB authorities think they have already done too much by buying $252 billion of eurozone bonds over the past year and a half. But compare this with the U.S. Federal Reserve, which has created more than $2 trillion since 2008 in efforts to keep the U.S. economy from sinking back into recession.
The ECB could put an end to this crisis by intervening in the way the U.S. Federal Reserve has done in the United States. But they continue to insist that this is not their role. That is the heart of the problem, and until this policy is reversed it is likely that the European economy will continue to worsen.