The Day After... Italy.

[Beet]

Well that (1 day rally) was fun while it lasted. Now back to reality...

"Italy paid the most since joining the single currency to sell new 10-year debt on Friday in the first euro zone bond auction after European leaders agreed new steps to tackle the debt crisis.
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The auction yield on Italy's March 2022 BTP bond rose to 6.06 percent from 5.86 percent a month ago.
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The yield on a three-year BTP maturing in July 2014 rose to 4.93 percent, at its highest since November 2000, compared to 4.68 precent at an end-September sale."

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As I have said before... either Germany will sign off on unlimited monetization or all the countries under pressure will default (and I consider any kind of monetary separation between Germany and the subject country a default). There is no other way. The movement of the markets are steady, swift and inexorable.

[Beet]

I work in computers... there are a couple others here in these boards who work in economics and finance who know more than me but they are pretty taciturn.

[Beet]

I have been interested in this for as long as I have been interested in computers, if not longer. So I presume that you do work in the industry?

[Beet]

Well, there's an article in the latest edition of Foreign Affairs that lays out the theoretical goal.

[Beet]

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Does this mean that CDS spreads will start to become an unreliable indicator of sovereign default risk? I've been looking mostly at yields anyway, but mostly because of what timely data I've been able to find on my own. I imagine this is a useful market because it would send signals more reliably than credit rating agencies.

[Beet]

Italian yields hit another record high today

“The European rescue plan is falling apart even faster than I expected,” Mr. Krugman said on his blog. “[If] the debt must be rolled over at [above] 6 per cent, given the size of Italy’s debt, that vastly increases the primary (non-interest) budget surplus Italy needs to stabilize its position. And that difference is quite plausibly the difference between paying its debts and defaulting. So we’re deep into self-fulfilling pessimism territory here. Either the ECB moves in with big purchases, or the euro is crostini.”

Germany: The cards are in the air. Make your choice. The idea that Spain and Italy will go down the Greek path and succeed where Greece has failed is sheer lunacy. Paul Krugman and the Anglo economists are right on this one. ECB must either step up or all of Europe must prepare for a cascade of sovereign defaults now.

[Beet]

Italian expenses are about 600 billion euros and about 200 billion euros in debt are coming due in the next year. Under the worst case scenario, Italy is shut out of the markets, it will have to pull off a fiscal adjustment of 200 billion euros in the next year, on top of what will surely be surging unemployment and collapsing banks that will need recapitalization. That means a 1/3 cut in total spending in the context of a collapse of the economy, all in one year. Even if Italy were not completely shut out of the markets, it would be foolish to issue debt at prohibitive yields, for this will only result in an ever-increasing spiral.

Politically, the best move for the next government is not to enact specific cuts upfront but to enact 'automatic' adjustments that legally mandate the government will reach its debt targets. The problem in Greece is that each new round of cuts needed a new vote. Instead, they should just pass one will that will contain with it automatic cuts whenever targets are not met. This way, the cuts are insulated from the political system. I think the focus should be on spending cuts, not tax increases, because taxes all face collection risk, whereas spending cuts only involve turning off the spigot. The government must assume strikes and massive civil disobedience and be prepared to crush them.

Alternatively, the new government can come into office on Day 1 and say 'f--k you' to Brussels, restore the lira. If they have the guts to do this (which I doubt) they will initially face near revolution, but if they can survive for 6-12 mo. eventually become the Kirchners of Italy and still be enjoying glory after 10 years.

[Beet]

Even as I was typing that, I knew that a 200 billion euro adjustment in 1 year simply isn't impossible. If Italy is effectively shut out of the markets there is absolutely no way it will avoid some sort of default.

[Beet]

Torie- basically it's a big disaster. I don't think they need fiscal union *necessarily* but they also aren't going to make it with their current mentality.

[Beet]

Gustaf,

But that depends on what you mean by Germany 'paying' for the Club Med countries. Arguably, simply by being in a currency union with the Club Med countries, Germany is paying for them already, because it is supporting their purchasing power and they are leeching off Germany's purchasing power. Also, the EU has a ton of agricultural subsidies, etc. etc. The free trade zone, movement of labor agreements, even the forced austerity and restructuring are all forms of German subsidy to the weaker countries. So if that's the principle you're after, it's been violated long ago.

[Beet]

Gustaf,

But that depends on what you mean by Germany 'paying' for the Club Med countries. Arguably, simply by being in a currency union with the Club Med countries, Germany is paying for them already, because it is supporting their purchasing power and they are leeching off Germany's purchasing power. Also, the EU has a ton of agricultural subsidies, etc. etc. The free trade zone, movement of labor agreements, even the forced austerity and restructuring are all forms of German subsidy to the weaker countries. So if that's the principle you're after, it's been violated long ago.

True, but that seemed to them at least to be a worthy deal like it was for China and the US. Where they draw the line is when they can actually force Germany to make a direct transfer payment or sign up for a future direct transfer payment.

What? China or the US never signed up to any such thing. And the Common Agricultural Policy is direct transfer payment.

[Beet]

It isn't about what principle I'm after, but what the Germans want.

Oh I'm not saying anything about what Germans want. I agree that they don't like these subsidies... I mean who would? I'm just saying that it's hypocritical to draw the line at subsidy as a principle because it's already been violated several different, major ways.

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Again, that depends on what you means of 'exists independently of the economy in general'. Agriculture is certainly a part of the economy, and it is indeed a huge subsidy, and quite real. But the other things I mentioned: free trade zone, free labor movement, common currency, and certain common governance rules are also a form of subsidy. Not to mention, the ECB subsidizes the national banks of the Club Med countries by giving them risk-free overnight loans.

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Yes, it's been there from the start in a big way. And it's an important point, because, the only reason why Germany must complete the circle to avoid catastrophe is because it began drawing the circle in the first place.

Germany is like a human that finds a cute baby pet in the forest, takes it home to raise it. After a few months it has grown big and no longer cute, but since it has been coddled for so long it can no longer raise itself. The choice is to keep raising it, or throw it out into the woods to die. Had it been allowed to remain in the wild in the first place, it would be able to survive on its own, but now it cannot...

[Beet]

True but by starting the 'printing presses' Germany isn't technically paying anything because it isn't German money. It's just currency created out of nothing. The impact on Germany comes from only secondary sources-- by increasing or decreasing the euro exchange rate.

[Beet]

But since Germany is the biggest economy and since its "currency" was the most undervalued by switching to the Euro you and me both know that inflation would be particularly bad in Germany and they don't even get to benefit from the ECB bond purchases.

But that's a secondary effect, not a direct effect. Just like, the Euro is devalued simply by Italy's membership inside of it, is a secondary effect. Plus we don't even know that it would be inflationary at all. The Euro would rally if the crisis were resolved, and that would deflationary.

[Beet]

I disagree, but I don't want to get into a long discussion now. Let me just restate that I think there is a strong chance such an action would result in a higher-valued Euro than the alternative of continued deepening of the crisis.

[Beet]

But what evidence is there that European governments would "borrow to the hilt" as you say, and then "blackmail the ECB"? You talk as if European governments were rabid animals without restraint or intellect. I give them more credit than that. Surely they would see that what you describe is a tragedy of the commons scenario and not do what you say.

I mean, is it not fair to say that during the first seven years of the euro, no European governments felt any fear of bond vigilantism? And during this time, they did indeed run up deficits. But not nearly so much as you say here. Further, the Euro during this time did not depreciate to a value 'less than the drachma' would be worth. It actually appreciated from about par to the dollar to well more than the dollar. And certainly this crisis has focused the minds of Europe's democracies on the problem of debt more than they had been before.

[Beet]

No, I think you were misinterpreting me. I said breakup of the Euro with the northern countries leaving would be a good outcome. This discussion is obviously assuming that does not happen (there is no sign of it happening). I said default was inevitable given the curren path, and I still think so. But they could avoid it with an ECB guarantee backed by printing.

The key problem is the behavior of democracies and whether they can be trusted to maintain discipline within a multicountry currency union if the threat of default is taken away by the central bank. Perhaps there can be a compromise: In exchange for the ECB agreeing to buy as much Italian debt as necessary to end the crisis, Italy will agree to either a law or a Constitutional amendment (this would require a referendum) mandating some version of the SGP, replacing the 3% deficit limit with a balanced budget requirement across a business cycle; and the 60% debt limit to something closer to Italy's historical average in the past 20 years. Also as part of this law/amendment, it will supercede the annual budgeting process and implement automatic fiscal adjustments in the case the legislature is not able to comply. To break the rule, the legislature would have to take positive action. The ECB would naturally monitor the legislature and inform it if it were about to break its own domestic law or Constitution, and if it chose to do so would dump all of the country's bonds into the open market. In the face of such a structure I am confident that even a special-interest controlled, corrupt legislature would not "cross the Rubicon" and would maintain fiscal discipline.

[Beet]

But what evidence is there that European governments would "borrow to the hilt" as you say, and then "blackmail the ECB"? You talk as if European governments were rabid animals without restraint or intellect. I give them more credit than that. Surely they would see that what you describe is a tragedy of the commons scenario and not do what you say.

They'd see the tragedy of commons, but you will have taken from them the only mechanism out there to prevent falling into it. That mechanism right now is the merciless ECB, that won't budge no matter what and the implicit threat that the "misbehaving" country will be treated like Greece is treated now. Take those away without providing other mechanisms (i.e., political and fiscal integration) and you create the situation in which any "responsible" government would, in fact, be grossly irresponsible to its own voters - it would be letting the others to suck them dry.

But Italy will be punished now even when it is not misbehaving. All of the reforms they need take time. They need to change the entire structure of their economy, if not their entire national culture. They'll need longer than the couple of weeks the bond markets will give them to do it, and because of their size, a Greece-style bailout seems out of the question (and poorly advised).

Also, what do you think of my proposal of 1:29 pm?

[Beet]

Italy must refinance 200 billion euros in the next year, while revenues and expenses are roughly 600 billion euros. Italy has about 75 billion euros worth of gold bullion. If it sells all of its gold bullion, refinancing remains 125 billion euros. If one expands beyond gold to all foreign exchange reserves, Italy has 125 billion in foreign exchange reserves. Refinancing costs fall to 75 billion euros. If the IMF and the EFSF can be persuaded to cover the remaining 75 billion, Italy is solvent for the next year with no revenue-adjusted fiscal adjustment.

[Beet]

@opebo: The ECB is not allowed to buy debt directly from governments. Unlike some of its other, errr, unusual traits, that one is actually fairly standard among world central banks. It can only buy on secondary markets.

Italy must refinance 200 billion euros in the next year, while revenues and expenses are roughly 600 billion euros. Italy has about 75 billion euros worth of gold bullion. If it sells all of its gold bullion, refinancing remains 125 billion euros. If one expands beyond gold to all foreign exchange reserves, Italy has 125 billion in foreign exchange reserves. Refinancing costs fall to 75 billion euros. If the IMF and the EFSF can be persuaded to cover the remaining 75 billion, Italy is solvent for the next year with no revenue-adjusted fiscal adjustment.

...and ZERO reserves whatsoever?
From bad to worse.

So what's your proposal, Italian? It's your country. (and yes. I've thrown out about five different proposals. I have certain preferences and beliefs, but right now I'm not completely wedded to any one solution, including this one).

[Beet]

Sovereign default is not the end of the world (who said it was?), but it's still pretty bad. To restate the obvious, Italy is a G-7 nation, part of the core of not only Europe but world capitalism. A default would be the biggest economic failure in the capitalist world for 65 years. It's bad enough to consider lots of different alternatives to see if any would be better. Keep in mind what Greece has been through in the past couple years, and they haven't even really defaulted yet. To Greece's 300 billion euros of debt, Italy has 2.5 trillion euros of debt.

Further, from a political standpoint, I don't agree that Italy should keep stringing along the IMF/EU and then default when the money runs out. If default is inevitable, I argue it would be better off defaulting straight away for the following reasons. First, it already has a primary budget surplus, so delaying default only means more interest payments that disappear into nowhere. Second, the IMF/EU will try to force through massive structural changes that the Italian people will not be able to decide upon democratically. It is better to keep economic decisions under the purview of Italy's democratic institutions. Third, look at what has happened to the Papandreou government. It has lost all popularity and credibility. A new government coming in straight off an election with a solid majority, would do better by defaulting straight away and taking as much economic pain as possible in the first year, so that by the third or fourth year when new elections are coming up, a recovery is already visible, as you hinted.

Finally, it is unclear whether or not even a hard default would resolve the problems here. The main examples pointed to (Argentina, Russia, Iceland) all combined default with a currency devaluation. Even after a hard default, is the country were still using the euro, it may not be able to avoid a hard internal adjustment, difficulty which is unpredictable. I cannot think of any historical examples.

[Beet]

And what if the markets are not reassured, despite enacting some of the measures asked by the EU? What then?

[Beet]

And what if the markets are not reassured, despite enacting some of the measures asked by the EU? What then?

A default is not the end of the world.

Again, no one said it was the end of the world, but it is a lot of money. I mean, we're talking about an Italian default here. This isn't peanuts. Come on, guys.

[Beet]

Sure, there are some good things that come when defaults occur. I just think the costs outweigh the benefits on this particular default. There may be a time when that is no longer true, but at the present time it is certainly very true, IMO.

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Oh there is no chance Italy will become like Sudan or Zimbabwe. Perhaps Argentina is more like it. But, because you have surrendered your monetary independence to Frankfurt, Italy does not have the power to defend itself from an uncontrolled default.

[Beet]

Sure, there are some good things that come when defaults occur. I just think the costs outweigh the benefits on this particular default. There may be a time when that is no longer true, but at the present time it is certainly very true, IMO.

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Oh there is no chance Italy will become like Sudan or Zimbabwe. Perhaps Argentina is more like it. But, because you have surrendered your monetary independence to Frankfurt, Italy does not have the power to defend itself from an uncontrolled default.

And it's not in the European interest to have an uncontrolled default.

I certainly don't think so... ...