Questioning Italy’s solvency means ECB intervention

Cross-posted from Credit Writedowns. Follow me on Twitter at edwardnh for more credit crisis coverage.

Disclaimer: This piece on the impact of Italy’s potential insolvency on the sovereign debt crisis is not an advocacy piece. It is supposed to be an actionable prediction of what I see as likely to occur.

Last week we witnessed a flight to quality within the euro zone government bond market. The yield on 10-year German government bonds dropped a record 35 points last week. German 10-year bonds now yield 1.82 percent. Meanwhile, the yield on 10-year Italian government bonds continues to rise, last quoted by Bloomberg at 6.37%, a record 455 basis points higher than German government bonds.

Clearly, Italy is now the biggest focal point of the European sovereign debt crisis. And, make no bones about, while the immediate concern for Italy is liquidity, at heart the European Sovereign Debt Crisis is a solvency crisis. Let’s take a look at Italy to see why.

The “Complete Strategy”

On October 26th, the EU announced to great fanfare that it had hammered out a “complete strategy” to deal with the ever-widening European sovereign debt crisis. The text of summit statement showed three pillars upon which this strategy rested.

  1. Sustainable public finances and structural reforms for growth: “The European Union must improve its growth and employment outlook, as outlined in the growth agenda agreed by the European Council on 23 October 2011… All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms.”

  2. Stabilisation mechanisms: “We agree on two basic options to leverage the resources of the EFSF: providing credit enhancement to new debt issued by Member States, thus reducing the funding cost…; maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles.”

  3. Banking system package: “There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures… Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”

The first of three pillars addresses solvency of euro area national governments while the second addresses liquidity. The third addresses both the liquidity and solvency of euro area banks. But will this solve Italy’s problems?


Italy’s problem is this: Italian government debt is almost 120 percent of GDP, behind only Greece within the euro area. Meanwhile, Italy pays 6.5% for its long-term debt. If interest rates were to remain at current levels for an extended period, Italy would need to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant.

As a reminder, the plan is to have Greece’s private sector creditors reduce their claims enough to get Greece to this level, which the EU is calling sustainable. My suspicion is that the 120% debt target for Greece is largely a function of not wanting to suggest that Italy’s debt levels are too high.

How can Italy get out of this trap?

Lower interest rates: The plan presented by the EU was to relieve Italy of its interest rate burden by leveraging the European bailout facility, the EFSF. In order to do this, the Europeans need a “combination of resources from private and public financial institutions and investors”. We know that European banks are undercapitalised and European countries are in the midst of a sovereign debt crisis. So no funds are going to be forthcoming there. The United States is having its own fiscal battles and cannot take the lead. That leaves the biggest developing countries, China, Brazil and India and oil rich sovereigns to bail out the Europeans. The Chinese have already said they are not going to get involved and the amount of resources Europe can get from elsewhere is not nearly enough to backstop Italian government debt, the third largest government debt load in the world unless the Europeans are relying on aliens to fund them. So this pillar of the three-legged stool is broken – at least for an economy the size of Italy’s.

Growth: Given the fact that Italy has one of the lowest ratios of births to deaths in the world, it also has a rapidly aging society, which limits potential economic growth. Even if domestic GDP expands by a wildly optimistic 2 percent per year – it has expanded less than one percent over the last decade – you would need 3% growth from exports in order to stabilise the debt to GDP ratio at 120% at prevailing interest rates. That is never going to happen. So this leg too is bust.

Austerity: The Europeans are pushing Italy to make structural reform. But the Italian government has been unable to make these reforms. Prime Minister Berlusconi priorities seem to be elsewhere and his government is weak; likely the government will collapse. Even so, Italy’s labour minister Maurizio Sacconi warns that rushing through the labour market reforms which the EU demands risks creating the preconditions for a wave of terrorism. Wow. Do you really think, the Italian government, which seemed to have a different governing coalition almost every year for most of the post World War II era, is going to be able to push these kinds of draconian reforms through? And I haven’t even mentioned budget or public pension cuts.

The Italians don’t have a leg to stand on.


This approach is the easiest and therefore a very likely outcome. Let me frame what I think the issues are and how to go about it. Note, this is not an advocacy piece so I am framing what could occur more than what I would recommend.

The monetisation scenario ostensibly involves an attempt to separate liquidity from solvency issues by using the currency creator’s power to stand behind debt obligations with a potentially unlimited supply of liquidity. This is the traditional lender of last resort role that a central bank is expected to play. For example, the Fed played this role in buying up financial assets during the crisis in 2008 and 2009. Of course, it did so recklessly by buying up dodgy assets at inflated prices instead of good assets at penalty prices so as to discriminate between the illiquid and the insolvent.

Now that the credit crisis has moved on to sovereign debt, the central bank can play this role with sovereign debt as well. The best way to accomplish this task would be to start buying enormous quantities of sovereign debt, inducing a huge shift in the price/interest rate of those assets. Only afterwards, the ECB would announce that it was prepared to supply unlimited liquidity to stand behind these assets at specific target interest rates and would do so at the most inconvenient moments for speculators wishing to make a quick euro. (Update: see comments of a similar nature after this was written from Willem Buiter at the bottom.)

The point would be twofold:

  1. Market participants would understand that the ECB had unlimited means to back up threats with action, the stress clearly on the word unlimited.
  2. Market participants would understand that the ECB intended to penalise speculators by targeting them with its unlimited liquidity.

As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout. On the other hand, it could be a possibility for Spain because Spain is simply too large to bail out in the way that Greece and Ireland were bailed out.

The immediate impact of this kind of action would be a rise in the euro-denominated gold and silver price, currency depreciation more generally, and increased inflation expectations. So this is a beggar thy neighbour economic policy – competitive currency devaluation, if you will.

Three options for the euro zone: monetisation, default, or break-up, Nov 2011

I wrote these paragraphs one year ago and I see nothing that has occurred since then which makes me want to change anything. In fact, the events of the past year make me think this is all the more likely. Italy was not a factor then; it was Spain which was the problem. Italy has the third largest government bond market in the world. In July, I also mentioned that Italy owes German banks 116 Billion euros. If Italy were to default, the result would be financial Armageddon and a major worldwide Depression, perhaps one worse than the Great Depression. The Germans know this. And as I outlined above, the route to a sustainable solvency path that leads to liquidity for Italy is blocked at every path. Italy will continue to pay a huge premium for its debt. The only way to ensure Italy’s medium-term solvency is to have it borrow in a currency whose creator is credibly committed to creating an unlimited supply of money in order to backstop Italy’s debt if necessary.

At present, the ECB is buying just enough bonds to send a message to Spain and Italy that they need to live up to their austerity quid pro quo or else the ECB will stop buying. The ECB wants to prevent ‘free riders’ from making the euro a weak currency. But, let’s be clear, a currency with “no lender of the last resort” was a ridiculous concept from the start. The crisis we are witnessing now was always going to happen. As much as the ECB resists it now, they have limited choices: monetise or face a global economic collapse. The longer they wait, the worse it will get.

This post was the first in a series on Italy that I began on Sunday. Read the second on the second on Why Investors will buy Italian bonds after ECB monetisation. I will have more today or tomorrow.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Eric

    Why do you call reforms austerity?
    You may question the viability of reforms, but in every economic report by organisations like IMF and OECD it’s being listed as the first solution. Italy does have the potential.
    Even better: Italy has the money. Private debt is low and they have a large black economy (estimated 30%). This is not just my opinion, these are the words of their finance minister.
    So the Italians do have a leg to stand on. There is absolutely no reason why the rest of Europe, or the world, should come to the rescue of Italy.
    Unless….. the Italians are given the easy option of monetisation. That’s what they are hoping for!

    1. sidelarge

      “in every economic report by organisations like IMF and OECD it’s being listed as the first solution.”

      Yes, such reputable and partial organizations as the IMF, and even better, the OECD. How could they be wrong on economic matters. Or the Italian finance minister, of course.

      The problem is your entire premise that “reform” will lead to “growth” and the market will wait patiently for that end result. Or if you aren’t even thinking of growth and instead only of reducing budget deficit, which is almost non-existent by the way, your premise is even more flawed.

    2. tts

      “but in every economic report by organisations like IMF and OECD it’s being listed as the first solution”

      Uh those are 2 of the most pro rich/status quo financial organizations in the world and their track records for success are pretty horrible.

      Their version of “reform” = austerity.

    1. Jim

      Neither do I.

      Edward, since this monetization you describe clearly violates the German constitution and Article 123 of the EU Treaty, why not put it for a vote in Germany?

      Why is it that so many NK readers who would otherwise be very critical of the Republicans violating democratic principles are so forgiving when the Eurocrats do so?

      We would be up in arms if the GOP argued that the American people are too “ignorant” to know what’s good for them, and that an end to, say, Medicare as we know it is necessary for the good of the country.

      But when a few misguided Eurocrats in Brussels say the same regarding monetization and the need for Germans to shoulder higher inflation, and the Greeks and Italians to submit to austerity, we say nothing.

      I say, let’s support what’s best for the voters in Germany and Greece.

      Let’s support the dissolution of the ill-conceived Eurozone.

    1. Jugo1502

      That may have been the swiftest and smoothest near-invocation of Godwin’s law in interweb tube history! +666, Jo!

      Nevertheless, bravo! Very funny.

  2. Sy Krass

    Investors will start buying Italian bonds after monetization? I don’t think so, and if they start buying Italian bonds (and they will) they’re going to have to eventually buy all of them.

  3. Sy Krass

    On the other hand…if Weidmann is correct, it’s a matter of weeks before collapse, Italy’s bond market is too big. And then again…maybe the ECB can’t print money the same way the fed has (up to this point anyway) because they’re not THE reserve currency all interest rates in Europe may spiral up regardless.

    1. sidelarge

      I doubt whether the euro is the reserve currency or not has much bearing in this situation.

      As for Weidmann, I don’t know if we should regard his very strong wording as an attempt to to draw the final Maginot line of defense, or something else. To be frank, though, I still remember his brief analysis and diagnosis on the euro problem that he revealed around the time when he took over the position, and it didn’t give me any confidence that he had any idea about what was going on. To be honest, his explanation was borderline nonsense.

      1. Sy Krass

        You may be right, but without the reality (perception?) of the US dollar being the reserve currency, I doubt the US would have anywhere near the low interest rates it does right now.

          1. nikhil

            UK, Australia.

            Reserve currency doesn’t seem to have anything to do with it. If you are sovereign in your currency you don’t require private borrowers to fund your govt spending like the EU countries. Yields can be modified by your central bank.

            Investors know the EU countries, without a lender of last resort, are at their mercy so they will extract the highest price possible. A government constrained by the free market that’s the neo-liberal end game.

  4. Phil

    This analysis presumes Germany will eventually choose Europe over its current account surplus. What is the public support for this position in Germany, and how accountable are the politicians to it?

    Obviously, Germany leaving the EMU has most of the same effects due to an undoubtedly strong DM, but the optics may be better for German politicians. How likely is it that they would abandon the Euro rather than permit the ECB to become the European lender of last resort, spending their money and superceding the Bundesbank? Are they okay with that loss of sovereignty?

    I welcome answers to these questions from people more educated than me in these matters.

    1. Jim

      According to public opinion polls, 75% of Germans want less Europe, not more.

      Of course, the Eurocrats in Brussels argue that the German voter is simply too ignorant to know what’s good for him.

  5. Ishmael

    Even though this analysis might be correct it assumes that politicians will act in a rational manner. Since that has not happened during the last 30 years or the world would not be where it is currently.

    My bet is totally denial on the politicians part until the wheels come off. Then stay as far from the fan as you can because it is then going to be total chaos.

    Probably the Greek govt will declare a bank holiday to stop runs on their bank which will trigger similar runs through out the PIIGS. By then it will be to late to do anything but sit back and watch.

  6. Economics Considered

    Seems like the article could quite readily be applied to Greece, Portugal, and Ireland. Spain may be a slightly different scenario.

    Quite a consensus seems to have developed among the key blogs that perhaps the only solution left to retain the EZ intact would be to start printing money (blunt terminology for monetization). It is hard for me to think that Germany would be willing to absorb their economic detriment should that be done.

    There have been thoughts about perhaps a split EZ that I have seen (apologies – no links).

    Presumably that would group Germany, Netherlands, Finland, Austria, and perhaps some of the other small countries as one EZ. And would group the remaining countries, I would expect including France, in another EZ.

    The advantage is obviously considerable. The second group could attempt to print their way out of the exchange magnitude of their debt and gain some modicum of a possibility of increased exports. The first group could maintain their present economic equilibrium and approximate exchange valuation without the ravages of printing currency.

    And, there would remain structures in place for currency union(s) with a vague anticipation that the two groups could merge again at a later time, likely only if some additional political centralization could be worked out.

    On the surface, it would seem like a pragmatic solution. However, the devil would be in the details – and I’m not sure I could see a possibility of a resolution of interests being hammered out.

    Other than that long shot, I don’t have a feeling that there is any resolution short of dissolution. Two years ago, there might have been a very slight chance. But so much additional debt has been built up – and the banks are that much more insolvent with increased sovereign debt exposure. ‘Managed’ defaults on a country-by-country basis would have to be so massive at this point that the EU cannot absorb it without crashing.

    It seems almost certain that Germany’s self interest is going to dictate – much sooner than even moderately later – that it break away on its own, even though the pain of extraction after the embroilment of two years of kick-the-can is going to be close to ruinous. It would interesting to see if they might find it extremely difficult but desirable to unilaterally form the reduced EZ with the Netherlands, Finland, et al and leave the rest of the countryies to come to their own resolution. One interesting carrot for Germany (and group) to do so soon would be to avoid the sinkhole of their promised contribution to the EFSF. Those are not insignificant amounts when every Euro of capital is going to be precious in trying to retrench.

    Just some pondering.

    1. Howard L

      I believe the ECB will become the lender of last resort by guaranteeing all bank debt. This will be done next year after all the social safety nets are dismantled or on their way to being destroyed through austerity. The goal of the Troika is to make Europe look like the United States, minimal social programs and a liberated labor market.

        1. Howard L

          I hope not, but the goal of the IMF, ECB, and the European Commission is to attack the social safety net, while bailing out the bank creditors. Please take a look at Dexia, where creditors were made whole costing several billion Euros while Sarkozy introduces an austerity budget. Of course, the people are fighting back all across the region and the outcome of this struggle is still not known.

        2. okie farmer

          Jim, Howard L is exactly right about the goals of the Troika. The EU may not have been concieved as a way to neoliberalize Europe, but it took very little time for the neoliberals to see their opportunity to hijack the project. Barroso has been outspoken about it, as was Sarkozy and other leaders prior to the crisis. ‘We must become like the United States… dah, dah, dah’ or we will not be able to compete. Not to mention the Financial Times’ and The Economist’s never ending pronouncements that Europe will collapse tomorrow if the social programs are not dismantled.

          From my perspective, it appears obvious that the Europe wide social programs, particularly socialized medicine, the vast high-speed rail systems owned and operated by govts for the most part, are a huge competitive advantage. And maybe that’s what makes free-marketers so angry. This system really works, and well, creating the E currency was poorly done, and I’m beginning to think like P Pilkington noted in a post he did several weeks ago, maybe the Euro was created to fail in order to allow the neoliberals to loot the lootable countries and destroy labor and the social programs.

  7. Economics Considered

    By the way, one of the enormous assumptions involved with the ECB printing Euros – is that there would be still be a sizable market for low interest rate Italian (et al) bonds. In fact, one could surmise that the enormous delusional hope of the EZ-crats would be that the threat of unlimited ECB capacity to ‘control’ the bond interest rates would be that they would actually not have to buy all that many bonds in order to ‘influence’ the market. As I say, I think that’s highly delusional. More likely (as mentioned) would be that the ECB would have to ‘buy’ almost all of the ‘bond’ debt.

    But the interesting question directly related to that is – would there be any market for Italian (et al) bonds at, say, 4% interest ???? Why would anybody buy bonds at that return with the remaining substantial risk involved ?? Anybody ‘know’ the bond market well enough to figure that out ? A subsidiary question would be – what rating would the agencies give to Italian bonds in that scenario ?

    1. William C

      That is a good set of questions to which I do not have the answers, but just express the thought that at present the market price for Italian debt is probably being set by the ECB as the only significant buyer. In that context it is interesting that yields have gone up in the week since Draghi took over at the ECB and Berlusconi looks to be on his way out, probably partly as a result. One question which does seem to have been answered then is whether Draghi was going to ride to the rescue of his compatriot. The answer seems to be no. This at least is one piece of good news. Whatever the chances of sorting out the current mess may be, I hold out little hope if Berlusconi sticks around.

      1. marc fleury

        This point was argued by Pimco in the US stating that too must QE pushes out private investors and ultimately reduces the level of liquidity. In all honesty that was after QE2 onto QE3. Europe is still at QE0 I say let it happen and move on.

  8. Hugh

    Europe is crashing and burning. Look at the problems, look at what is needed, and look at what has been proposed and is likely to be proposed as a solution. It isn’t just that the needed solutions and the proposed solutions are not remotely close, or that the whole trajectory in policymaking over the last year and a half has been strongly negative, it is that none of Europe’s core problems have even been addressed: for the nth time, a lack of a fiscal and debt union, a weak ECB, mercantilist trade patterns, banksterism, corrupt political leadership, and a parasitic kleptocratic class of the rich.

  9. Clueless1

    If you are a bank (FCM, whatever) in the private section and you own too much european sovereign … you go bk within days. even if your gross (not net) exposure is too high.

    Other than the ecb … who exactly could buy that paper? Let’s not even touch who would ever want to do so.

  10. Dan G

    Printing is the hall mark of the global Ponzi scheme. This is all the bankers know, and it is what they need to continue. The corruption of capitalism will continue simply because it must until it implodes due to “incidents” which happen with more frequency as time goes by.

  11. Fiver

    In short, though not “advocated” by the author, the most likely outcome is the banksters win, there is an enormous round of money-printing behind one or more BS balance sheets, the utterly corrupted elites and the permanent (and growing) underclass stay exactly where they are, while those in the middle class inclined to save or dare think of a pension are forced into predatory markets of their own “choice” (or betrayed yet again by fund managers). Everything in place for another round of capital/power concentration courtesy of bogus CDS “hedging” circle-jerk madness.

    Note that’s what Barclays is aggressively selling:

    This prescription, since its only function is to square the circle to keep the powerful firmly in place, is a disaster for the peoples of Europe – as it has been for Americans’ future each and every day since this began.

  12. Andrew

    You have to laugh.

    It’s getting harder to prolong the crisis than fix it.

    Like when you tell a really bad lie then have to keep inventing more lies to support the first lie.

    Just give up……say my bad, buy periphery debt and issue a load of Euro bonds.

  13. Philip Pilkington

    Quick point(s):

    “As Willem Buiter first mentioned last November, the ECB will not risk its anti-inflationary credibility to monetise the debt of smaller euro zone countries like Greece or Ireland. This is why they were forced to take a bailout.”

    Trichet has said that these policies are non-inflationary. There’s a bit of confusion surrounding the ECB bureaucrats on this — but the top-dog has admitted bond purchases are non-inflationary:

    And just a side note for all the MMT doubters. Warren Mosler called this in 2001. 10 YEARS AGO!!! That’s an amazing prediction to make. Look:


    “A prosperous financial future belongs to those who respect the dynamics and are prepared for the day of reckoning. History and logic dictate that the credit sensitive euro-12 national governments and banking system will be tested. The market’s arrows will inflict an initially narrow liquidity crisis, which will immediately infect and rapidly arrest the entire euro payments system. Only the inevitable, currently prohibited, direct intervention of the ECB will be capable of performing the resurrection, and from the ashes of that fallen flaming star an immortal sovereign currency will no doubt emerge.”

    Cullen Roche called this the greatest prediction of the last 20 years. Not because it predicted the Euro would tank, but because it predicted it with such accuracy. MMT gave a blow-by-blow account of the major events that are unfolding right now — TEN YEARS AGO, at least! Cullen’s piece:

    I agree, this is the greatest economic prediction of the last 20 years. Investors take note!

    1. Eric

      let me try to get this right: from the money printing by the ECB, an immortal sovereign currency will emerge?
      Sounds too good to be true to me.
      Let me make another prediction: the ECB needs to keep it’s cool, faced with countries defaulting, even with Italy.
      It will be a mess, banks will have to be rescued, but in the end the ECB will have shown the world that the euro stands for a stable currency, for a store of value, over rescuing insolvent over-indebted countries and incompetent politicians, and than an immortal sovereign currency will emerge.

      1. Philip Pilkington

        Oh yeah? It worked in the US pretty well. Japan too. Oh, not to mention post-Cold War Germany.

        If you have specific objections, by all means raise them. Otherwise step aside… history is on the march!

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