For several years I have predicted that, at some stage, the economy would either contract and lead to a depression of 1930’s proportions or that inflation would gain the upper hand, these mutually exclusive alternatives being the only possible solutions for reducing the excessive indebtedness accumulated in the system. We are now fast approaching this point.

 

In the face of the patent incapacity of the political and regulatory authorities to agree on a comprehensive workable plan for dealing with the looming crisis, which must, of necessity, include a first step in the direction of a limited “fiscal transfer union”,  it is hardly surprising that markets are seizing the initiative, privileging their own interpretations and thus are playing by default a determining role in shaping events.

 

The Italian case illustrates the conundrum we are facing. Let us assume that in a show of national unity, the Italian Parliament enacts by Friday the €40 billion austerity measures aimed at restoring a balanced budget by 2014, meaning annual savings of some €13.3 billion.

 

At the same time, the cost of refinancing maturing Italian debt is soaring as demonstrated by yesterday’s “successful” auction. This is reflected in the record spread with the benchmark bunds which, in turn, is the result of an absolute drop in bund yields and an increase in Italian yields. The drop in the former reflects essentially a “flight to safety”, while the increase in the latter expresses heightened risk perception. If and when markets stabilise, it can be expected that bund yields will return to a level  more in line with inflation expectations driving all interest rates higher and further affecting adversely Italian refinancing costs. This means that unless the Bund/Italy spread decreases dramatically (an unlikely prospect ahead of real progress being made), the budgetary gains derived from the austerity package are likely to be wiped out entirely by higher debt servicing costs.

 

On the other hand, if bund rates were to remain more permanently at the current lower levels, it would probably be the reflection of a poor economic outlook for the EU in general and Italy in particular. Any sign of a real improvement in the EU economic outlook will automatically lead to further tightening by the ECB, in accordance with its mandate to anchor inflation at slightly below 2 per cent over the medium term.

 

It follows that Italy is caught in a kind of debt trap where any improvement in the economy is offset by an increase in debt servicing costs, while a stagnating economy will put further pressure on the budget and lead to demands for additional austerity and higher yields to assume Italian risk. This “catch 22” situation must ultimately lead to some kind of restructuring of the Italian debt. In the present environment and absent an independent Italian Central Bank, the high proportion of Italian debt held domestically does no longer constitute a protective shield, as is often argued; on the contrary it could well prove to be its Achilles' heel. Indeed a very large amount of this debt is held by the domestic banking sector which itself is heavily exposed to the euro-interbank market. The recent dramatic fall in equity prices of Italian and other European banks – French in particular - is ample evidence of the interconnectedness of the banking sector, and is an additional illustration of the excessive interdependence between governments and their respective banking sectors.

 

In light of the foregoing, it will prove totally inadequate to limit EU intervention to a plan aimed at restoring Greek, Portuguese and Irish finances. The inclusion, however late and welcome, of a decrease in interest rates charged and an extension of maturities, will be far from sufficient to restore confidence. At least two additional important ingredients must be part of the solution:

 

- Ensure the total transparency of the bank stress tests to be released on July 15th. This must disclose the full impact of the sovereign debt crisis on bank balance sheets and the credibility of government support for institutions failing the test. This implies in turn the solvency of the government.

- Amend the mandate of the EFSF to allow EMU sovereign bond purchases in the open market. The ESM should be brought fully under the umbrella of the EU Treaty itself. It should allow for the issuance of “Eurobonds” benefiting from a full EU budget guarantee (with appropriate counter guarantees by EMU Member States in line with their undertakings agreed within the proposed ESM).

 

On the basis of the recent public declarations, it is highly unlikely that an agreement incorporating these minimal requirements will be forthcoming, though it is perfectly obvious that only a thoroughly comprehensive plan benefiting from unanimous EU Members State support is likely to restore the market’s confidence. Half measures will only render the cost of dealing with the crisis greater while running a considerable risk of inducing the implosion of the global financial system.

 

Brussels, 13th July 2011   

 

Paul N. Goldschmidt

Director, European Commission (ret); Member of the Thomas More Institute.