November 10, 2011
The Italy Factor Gets Ugly
Is the euro Toast? Maybe not, but if you thought the currency was under pressure before, well, you ain't seen nothin' yet.
The immediate issue is that the Italian problem has forced the European Central Bank into a put-up or shut-up moment. Bloomberg explains:
Italy is forcing Europe to choose between increased bond buying by the European Central Bank or a possible breakup of the euro.
Italian 10-year yields have breached the 7 percent level that locked Greece, Portugal and Ireland out of the capital markets and forced them to seek aid. With debt of 1.9 trillion euros ($2.6 trillion), more than those three countries combined, Italy has to refinance about 200 billion euros of maturing bonds next year and more than 100 billion euros of bills.
With so much uncertainty amid higher stakes, it's no wonder that Italy's government bond yields are rising, jumping north of 7%. The cost of financing Italy's debt burden is soaring, and eventually those chickens will come home to roost. By comparison, the 10-year Treasury Note yields around 2%. That's a hell of a spread for one of the planet's largest economies.
The next phase of the euro crisis is underway as Italy, Europe's third-largest economy, struggles to pull itself out of a political/fiscal crisis. The euro will almost certainly survive, but it's not going to be the same currency in the future.
Perhaps there'll be fewer members. Surely the rules for membership will change. Figuring out what it means to be a euro member is headed for a dramatic attitude adjustment. Meantime, it's a sign of the times when economists are offering detailed tips for exiting the euro. Stergios Skaperdas, an economics professor at University of California, Irvine, outlines a roadmap for Greece's departure, assuming it comes to that, which is no longer beyond the pale:
To minimize the number of days banks would need to be closed, the decision to move to the new drachma should be made on a Friday. Bank deposits and domestic debt would be immediately converted to new drachmas at the initial exchange rate. It would fall to the Greek courts to determine whether pre-2010 public debt would follow suit, but there is no reason to think they would treat it any differently from domestic debt.
But Greece is peanuts compared with Italy, and Kelly Evans recommends that we put the threat into perspective. "The risk of a serious hit to the global financial system from a European default is suddenly a clear and present danger, due to Italy," she reminds in today's Wall Street Journal. That country is the third-largest government debt market in the world, with about $2.1 trillion of securities outstanding as of March, according to the Bank for International Settlements."
The first question with the elevated euro mess is deciding if there's a blowback effect that will push America into a new recession? It's hard to model uncertainty, and the euro crisis comes with a lot of unknowns. But you don't have to be an economics wizard to recognize that there's a sizable risk here, perhaps the biggest yet since the Continent's troubles began several years back. Simply put, Italy's woes, given the country's size, represent a much larger threat vs. Greece. The danger of an outright implosion may be slight, but there's no getting around the fact that the best case scenario isn't all that appetizing either. Of course, it's a mistake to look at Italy in isolation. The main problem (still) is debt. A trio of IMF economists summarize the challenge for Italy, Europe and the rest of the developed world:
The global financial crisis has caused government debt to soar in the advanced economies. Public concern is rising and debates rage on how to fix the problem.
* In advanced economies, the average debt-to-GDP ratio is approaching 100% – higher than at any time since World War II, and set to increase further.
* The required fiscal adjustment is historically unprecedented.
It will take many years of chipping away at public debt to bring it back to more prudent levels.
We already knew that, but it seems that a fresher course via Italy is on the table. "If governments like Greece can’t reduce their debt through inflation, then a default where bondholders take a sizeable haircut on their debt becomes a more likely option, with all of the attendant costs in terms of lost output and higher unemployment," NYU economists David Backus and Thomas Cooley advise.
There's no easy way out. The only mystery is how the crowd reacts in the weeks and months ahead. It seems that we're on yet another precarious macro perch. Recent U.S. economic data hasn't been great, but it looked sufficiently buoyant to keep us from tipping over into a new recession, if only just barely. But even that modest bit of optimism is open for debate (again). The economic numbers of September and October are ancient history. Job One is looking for signs that the euro mess is infecting the slight revival in the U.S. macro trend. The margin for digesting trouble was already razor thin. Can it get even thinner without pushing us over the cliff?
The answer dribbles forth one economic number at a time. The next clue arrives later this morning with the update on initial jobless claims. Stay tuned…
Posted by jp at November 10, 2011 6:24 AM