The European debt crisis has entered a dangerous new phase — and its most prominent target, Italy, certainly looks like easy pickings:
- It’s a rapidly aging country that has seen hardly any growth for a decade.
- Its debt — the world’s third-largest and most immediately worrisome, at 120% of GDP — is growing progressively more costly, amid a sharp spike in bond yields, and could soon become unaffordable.
- Italy is led by a weak and corrupt government, tanking in opinion polls and looking to spend its way back into voters’ good graces
- Its size is such that, unlike the recent “rescues” of Greece, Ireland, and Portugal, an Italian bailout would be a massive undertaking that even a strong, united Europe could barely afford — to say nothing of the confused and divided coterie experimenting with various dodges and half-measures on Europe’s behalf.
So why do I think that the European bond vandals have just met their match? The main reason also relates to Italy’s size and strong ties to the core of Europe.
To lose Greece, Ireland, or Portugal is one thing. These countries really are peripheral to the European integration project, and so each has been allowed to twist in the wind — “rescued” from default by ultimately unaffordable further loans in exchange for the kind of austerity that has eliminated any chance of growth.
Italy’s a different story. Its ties to France and Germany are ancient. The watershed treaty establishing the European Economic Community was signed in Rome 54 years ago. Without Italy and Spain, Europe becomes really just Germany and France versus a bunch of Lilliputians. Without Italy, France’s continued membership starts to look tenuous. Without Italy, the euro zone begins resembling some latter-day Hanseatic League — a junior partner at best to the US or China.
So odds are it’s not going to happen. Southern Italy may be as sleepy and dispensable as Greece, but neither Volkswagen (VLKAF.PK) nor Renault (RNSDF.PK) would relish competing with Fiat (FIATY.PK) if the latter were to end up paying its workers in the new (and newly devalued) liras.
The people of Milan, Turin, and Venice consider themselves a part of Europe’s heartland. Their suspicion of southern Italy is as profound as anything Bavarians can muster.
For the moment, the same group of European policymakers that has fumbled the crisis so badly over the last year remains in denial. The crisis meeting of the euro zone’s finance ministers continues to haggle over the second Greek bailout, as if the Italian contagion hadn’t already made whatever they decide to do for Greece instantly forgettable.
The Germans are still resisting French requests to increase the pan-European rescue fund, which looked vast a year ago but now seems puny, as austerity’s toll on Greece is revealed in faltering tax collections and stubborn budget deficits.
The French plan for a debt exchange with Greek bondholders has flopped because many of those bondholders are hedge funds that bought their stakes at hefty discounts, and can therefore wait to see if Europe capitulates and buys them out at something closer to face value.
And, incidentally, buybacks of Greek bonds at a discount — which would amount to a managed default — are back on the table, after being ruled out by Germany a year ago.
None of this helps Italy, whose 10-year bonds are now yielding near 6%, despite no growth and a 2.7% inflation rate. Italy is paying a little over 4% on its current debt. If the recent rate spike does not retract, it will cost Italy something like an extra percentage point of GDP in interest payments on its public debt by 2015 ... and remember, this is a percentage point Italy really can’t spare. Meanwhile, Milan stocks are down 24% in not quite five months. Lately, they've been skidding a few percentage points each trading day.
So one day soon, after they get though crafting actual debt relief for Greece (or cut it loose), the Germans will need to decide whether Italy gets to go too, or whether they’re willing to double down on a fiscal union. If so, the next step would be to sell European bonds backed by Germany’s sterling credit, and use them to subsidize Italy, Spain, and the rest.
Getting cut loose would be better in many ways: Growth is what Italy really needs, and growth won’t come without a cheaper currency to compensate for Germany’s huge edge in productivity. But “better” has lost out to “good enough” in Rome for centuries, it seems, and “good enough” might be shelter from the storm under the skirts of the Bundesbank. As long as borrowing costs don’t rise from here, Italy could limp along for years before they become unbearable.
Given the European elite’s evident distaste for fundamental reforms, this seems like the likeliest outcome.
It will be interesting to see if Germany and France can get their act together before Rome empties out for vacations next month. Italy runs on its own schedule. And it will take something more than a global financial meltdown to keep the bureaucrats at their desks once the weather warms up.