The Italian Job

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. That said, see link at the bottom for the other side of that trade.

Michael Pettis liked my recent piece on vendor financing in the euro zone. The key point he wrote me – and which he reiterated just the other day – is that bad policies in “the surplus as well as in the deficit countries are at the root of the trade and capital inflow imbalances to which this crisis is the response” I agree with his contention that it is pointless to insist on adjustments only in the deficit countries.

That said, Michael agreed, however, that the euro crisis is not just a liquidity crisis. The European Sovereign Debt Crisis is a solvency crisis too. Countries like Italy are simply not going to be able to grow their way out of the problem. Everyone is recognizing this now. Until Italy was at the heart of the crisis, we could all delude ourselves that this crisis could be met with crushing levels of austerity in the periphery, even if that forced the economies there into depression. If Spain’s debt woes and Germany’s intransigence lead to double dip, then Italy’s debt woes and Germany’s intransigence lead to a Depression (with a capital ‘D’).

So, how the heck do we get out of this morass? My argument has been that with the central bank as a lender of last resort, solvency is meaningless for a government borrowing in a currency its central bank creates. In a nonconvertible floating exchange rate world, the adjustment mechanism is the exchange rate, not the interest rate. The last twenty years in Japan tell us that.


… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

Credit Writedowns, Oct 2009

That’s a soft depression scenario where the countries with a true lender of last resort can backstop without problems. In the euro zone, the ECB is not a lender of last resort… yet. And so the solvency issue cannot be postponed, monetised or inflated away and comes to a head. In fact, had the ECB been allowed to intervene as a lender of last resort earlier when just Greece was on the line in March 2010, we wouldn’t be here at all. Since then, the ECB has intervened only as a quid pro quo for more economy-deflating austerity, making things worse. And when they have bought periphery bonds they have been timid to prevent the currency-weakening moral hazard of ‘fiscal profligacy’. Credible lenders of last resort use price, not quantity signals. Everything in the sovereign debt crisis that has transpired since March 2010 is directly attributable to the ECB’s not acting as a lender of last resort.

As for Italy’s solvency, here’s what we know: Italian government debt is almost 120 percent of GDP. Since Italy pays over 6% for two-year money, rolling over debt contracted at favourable yields in 2008 or 2009 becomes excruciatingly onerous. Slow growth Italy’s debt to GDP spirals higher and higher at these levels. At German yield levels, Italy can sustain its growth indefinitely because it has a primary surplus already. I covered a lot of the ground in my last three posts Why questioning Italy’s solvency leads inevitably to monetisation, Why Investors will buy Italian bonds after ECB monetisation and Italy! Italy! Italy!

Here’s the thing: distinguishing between insolvency and illiquidity is a tricky subject because liquidity crises are the market’s way of shaking out the insolvent. Liquidity crises are always solvency crises. The question is about determining which debtor will not be able to repay future principle and interest in a world of incomplete information. If the questionable debtors are large enough, this leads to panic and a wider liquidity crisis that stresses the balance sheets of everyone, including the insolvent debtors. Indeed, the insolvent almost always are shaken out and bankrupted by this process (or are bailed out by government). The problem is that the shake out process kills a lot of other debtors too. If the crisis is large enough, a Depression results.

So, we are now faced with a question: Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

P.S. – Angela Merkel has a damn good poker face though. I think this could be why.

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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. brazza

    Investigative television journalist Milena Gabanelli (editor of RAI 3’s weekly “Report”) proposed that Italian debt be acquired by means of an imposed investment on the wealthiest Italians at 2 – 3.5% interest, removing the international market component. At first appearance this alternative seems to have value, not only in eradicating speculation, and reducing the influence of international capital on national processes, but more importantly it would likely give rise to a new sense of national pride and determination which is a component of reviving those animal instincts that lead recoveries. What would be the implications of removing say Euro 200B from the economy next year?

    1. Jim

      I concur. I much prefer that the wealthy in Italian pay for the bailout than the German middle-class family (via inflation).

      But 3.5% is too much. Pay them 0.5%.

    2. Archie

      I like this idea very much. I don’t know what the “proper” yield should be but at least this idea realizes that all Italians are in the same boat. If the wealthiest continue to look for zero losses, the masses will eventually extract their “proper yield” violently. In the latter case, Italian nationality ceases to exist. I think the Gomorrah and the Mafia would readily go along with this idea.

    3. PQuincy

      As an interesting historical note, forced loans from the wealthy were the standard way that Renaissance Italian city-states dealt with financial problems. Nice to think that a tactic invented by the Medici and their predecessors might come back into use!

      Of course, once they were ‘politicized’ by controlling the Florentine government, the Medici eventually bankrupted their bank. Sovereign debt is a very very dangerous game for all banks, because sovereigns can always repudiate debt: the very definition of sovereignty is being able to declare a bankruptcy any time for any reason, by whatever mechanism seems best. Such bankruptcies have consequences, of course — 4 or 5 of them over 50 years took Spain from the richest to one of the poorest countries in Europe after 1550 — but they are always possible.

      Whether Eurozone countries are sovereign is a little more complicated, though.

      1. SidFinster

        This was also the role of the “court Jew” in medieval and early modern Germany; loan arranger, whether voluntary or coerced. (The First Polish-Lithuanian Republic went so far as to institutionalize the arrangement; the Jewish community was granted autonomy, its own courts and parliament, in exchange for a regular fixed payment of taxes levied on the community as a whole.)

        As another aside, many anti-Semitic pogroms of those times were instigated by rulers who were either looking for new loans or who wanted free of their old loans. Sometimes it happened that the rulers would extend “protection” to the Jews, with the understanding that their aid would be compensated.

    4. Another Gordon

      I too like the idea of forced loans. Another plan (not mutually exclusive) would be to haircut bondholders who are and choose to remain, anonymous – hiding behind shell companies in the Cayman Island etc. They could avoid the haircut by credibly revealing the ultimate beneficial owner although that might lead to enquiries by tax and law enforcement agencies if everything is not kosher.

      In other words, confiscate the proceeds of crime.

  2. Nathan Tankus

    the Euro has created a Mercantilist mini-world. As in the Mercantilist era, the countries who lowered their general costs of production by keeping unemployment low, protecting industry, investing heavily in internal improvements and restraining rentier excess in the domestic sector developed current account surpluses that helped compound their success. Those who didn’t found their general costs rise, their society polarize, and when their bubble induced booms popped, they found themselves in a balance of payments crisis. If these countries don’t enter this brave new world (or more accurately, ancient) of currencies completely detached from commodities, their only other option is to act like the high cost developing countries before them. Namely, Britain, The United states, Germany and Japan. they need to protect industry, restrain rentiers, erect tariffs and redevelop a high wage, high skill labor force (which they are rapidly losing to emigration).

  3. craazyman

    Ouch. Holy cow here it comes, just like Quezequatl from the clouds! Ed I gotta hand it you, dude. You’ve been about right as rain throughout all this. And even though you get some grief in the peanut gallery from time to time (because nobody really understands this stuff, least of all us in the P-Gallery) you seem to understand it pretty damn well for an economist, or at least somebody who acts like what I imagine an economist acts like when they have a handle on things. I truly have learned alot from your posts and comments. Thank you for your efforts (“successes”, really, not just efforts). You’ve probably saved me at least $100G and I’m not even close to being wealthy.

    1. Jim

      But Article 123 of the EU treaty prohibits the ECB from acting like a lender of last resort. And the German constitution explicitly prohibits it.

      So why do so many continue to argue for something that is clearly unlawful?

      For a community that’s big on democracy, why do so many here ignore the wishes of the German voter who insisted on ensuring that the ECB could not act as a lender of last resort?

      1. craazyman

        my guess is they’ll either have to re-write that or explain it away as an aberration. ha ha. especially now that they’re confronting a force of nature. the money is like the breath of the European Lung and it’s pooling stagnantly in some sac someplace — probably a Goldman Sac — and there needs to be this oxygen administered so the patient can breath. this doesn’t mean the patient is going to move into a luxury villa without working for it — that priviledge is for the banksters — but it will the patient into a few more Porsches here and there and maybe a (what else is German? I never go shopping) I don’t know, say a big machine that makes huge things from metal with spinning wheels and gears run by some computer or maybe a Leica camera, maybe the M-9 even. ya vul!

      2. pebird

        First of all the ECB is also committed to financial stability, which is the reason the ECB used when they bought government bonds on the secondary market (read Auerback’s post for details).

        Second, the ECB is not an institution of the German state, the German constitution cannot dictate ECB policy, despite what the ex-Bundesbankers would like us to believe

      3. PQuincy

        And Article 456 of the may prohibit the sun from rising in the east. What of it?

        Laws cannot constrain natural processes, and the dynamics of the current crisis are driven by forces beyond those laws can constrain. That doesn’t mean that sovereign polities don’t have plenty of options: but we’re getting closer to the point where it’s their sovereignty (as a group or ultimately each alone) that authorizes their acts, not their laws.

        And as we’ve known since Bodin and 1576, a sovereign is ALWAYS above the law, because anyone bound by law even when that law is destroying them is not a sovereign, eo ipso. It’s worth remembering (despite the difference in context) Supreme Court Justice Robert Jackson’s famous statement, “The Constitution is not a suicide pact.”

  4. spooz

    tried to post this reply on your website, but its offline.

    you wrote in comments:

    “As I wrote on the RT post after this one:

    If you think about ONE fact, you will realise why monetisation is sustainable over the medium-term. If a central bank guarantees investors CREDIBLY that you can invest in certain debt instruments and NOT suffer principal or interest repayment risk, but only currency and inflation risk, some are going DEFINITELY going to buy the debt instrument with the greatest yield pick up. The ONLY reason not to buy Italian debt at 2 or 300 basis points over Bunds is because they are not credibly backstopped by the ECB. Think about it and you will see that this is true.

    That is exactly why investors were in these bonds in the first place. It was ONLY when the solvency issue came to a head that yields began to climb.

    I should also point out that this is the very same reason people like/liked the GSEs in the US and why they were nationalised with no hit to bondholders. People bought the GSEs because they believed them to be AAA securities backed by the Federal Government and the central bank. And they are!

    Does the ECB want to lose its trump card in dealing with Italy? No. That’s why they aren’t offering an explicit backstop. But if they don’t backstop Italy, Italian yields will remain elevated, Italy will default, all of the German and French banks with those bonds will be insolvent, and we will have a Depression. Italy is too big to fail.

    Again, the only way to credibly force Italy to get onboard is fiscal integration. That’s why a future rump Euro will have it or be comprised of more similar national economies.”

    I guess you have your MMT to back up this choice, but personally, I am tired of bank subsidies and can kicking. Time for the bondholders to take a hit. Control fraud (as described by Bill Black) should not be subsidized by taxpayers. Those who took the risk of buying bonds must take the hit. imo.

    1. Jim

      So did Argentina.

      And in Argentina, at the time, I recall so many arguing that if Argentina abandoned the dollar peg, the country would never recover.

      Well, Argentina left the dollar, and has subsequently thrived.

      Today, those same naysayers argue that Italy and Greece aren’t Argentina.

      What else can they say.

    2. richard wilson

      Whoa dude, please look at Iceland again. Its government held two different referendums in which Iceland’s masses voted “NO BAILOUT” both times, only to ignore the referendums, suspend the constitution, and dump the debt on the masses anyway.

      Or how about this gem: Iceland’s labor unions had put much of their money into the financial sector. When Iceland’s masses voted not to go into debt slavery, the unions still wanted the masses to pay them, so the unions passed a law indexing all debts (including sovereign debt) to the consumer price index. Since this law violated Iceland’s constitution, the government suspended the constitution. When Iceland’s banks collapsed, so did Iceland’s currency, which caused the price of imports to shoot up, along with the consumer price index. This increased the debt that Iceland’s masses must pay. Thus, Iceland’s peasants must pay much more than the actual debt the bankers and labor unions claim they are owed. And, because of this, vulture speculators that bought Icesave-based bonds at ten cents on the dollar will not only collect full original value of the bonds, but two or three times their value.

      So now, thousands of people are leaving Iceland to look for jobs in Norway and elsewhere. It’s Latvia redux.

      Oh, and if Greece had actually held a referendum, and it didn’t go the way the bankers and their puppet politicians wanted, then the Greek government would have done like Iceland’s government: just ignore the referendum and suspend the constitution.

      The public masses must pay the private speculators, no matter what. Welcome to absolute creditor sovereignty.

      The solution to all of this, of course, is to restore State (i.e. public) sovereignty over the money and central bank. That is, take back the money power from private bankers. This is the only solution that will really work, and the only solution that everybody avoids looking at.

      1. spooz

        It may not be smooth sailing for Iceland, but depositors were paid and bondholders faced default. The way Iceland handled the banks is something the US can look at with envy. The fact that the Icelandic government listened to its protestors at all gives me hope that such a thing is possible. It sounds like their fight isn’t over yet.

        Absolutely agree with your last paragraph.

  5. Fiver

    Is the semi-official discussion now being widely reported of a “core” EZ real or the latest stick with which to beat the PIIGS into total surrender? With Italian bonds breaching 7%, I rather think the latter – not that EZ exits for some is not part of the real solution, just that the “talk” could simply be another round of banksters, via Mr. Market, going for the throat to force an immediate capitulation to current terms – why wouldn’t that attack include their political mouthpieces as well?

    But in any case, I have a fundamental question: Why is the choice always presented as EITHER Armageddon in the form of a Depression OR some policy prescription or other that serves only to preserve the elite system architecture overall essentially as is? How can it not inevitably lead to a future, worse crisis just down the road if we keep “saving” so thoroughly rotted out a system run by a criminal class?

    The assumption is that if they/we choose “A” they/we get a decade of Hell no matter WHAT they/we choose to do next. Why accept that as even sort of inevitable? Why could this not actually be the opportunity to at last throw off this obscene financial/corporate tyranny? Far better to simply shut down markets for a time and let democracy work rather than be stampeded into permanent serfdom by a “Market” that long since ceased being a market.

    1. richard wilson

      We could have a “global debt jubilee,” but if we leave private bankers in control of the money, then we’d almost immediately be back to square one.

      “Banking was conceived in iniquity and born in sin. Bankers own the earth. Take everything away from them, but leave private bankers the power to create money, and with the flick of the pen they will create enough deposits to buy it all back again. However, take away from private bankers the power to create money, and all the great fortunes like mine will disappear — and they ought to disappear, for this would be a happier and better world to live in. But, if you wish to remain the slaves of bankers and pay the cost of your own slavery, then let them continue to create money.”

      ~~attributed to Josiah Stamp.

  6. jake chase

    We are witnessing a game of chicken between bond traders and the ECB. Because the ECB is “responsible” for political consequences it will lose. Italy will be bailed out because there is no alternative. Banks will accept haircuts. CDS will not be cashed in. I am not selling a single share and will buy more at SPY 116. Of course, I could be wrong, in which case the global economy will collapse and the sanscoulottes will take over. Don’t think I want to be a banker or bond trader if that happens.

  7. Steve Roberts

    Edward says German banks own $156 billion in Italian debt. Looking out 5-6 years he doesn’t seem to think monetization of the debt will actually solve the problem. Would Germany be better served just exiting things, taking the pain today and save themselves as much as possible?

    They will need to bankroll their banking losses eventually, why weaken themselves so much before realizing the losses?

    It feels like people underwater on their mortgages making payments they can’t afford (making their financial condition even worse) until they eventually recognize they should just walk away from the house and THEN pay their bills from a stronger financial position.

  8. Eric

    ”Everything in the sovereign debt crisis that has transpired since March 2010 is directly attributable to the ECB’s not acting as a lender of last resort.”

    so you really think that the Italian government had lifted any finger to do something about their debt levels, if only the ECB had intervened with acting as lender of last resort? I think that’s delusional.

    ”An Italian default means massive losses for German and Dutch banks and beyond”

    The French banks have the most Italian bonds, at a level they can’t survive (300bn). German and Dutch banks have much lower levels, and the power of their governments to backstop them.

  9. Economic Maverick

    Thanks Ed

    Can you explain this: “Liquidity crises are always solvency crises” ?

    I thought it would be the other way around, as Solvency crises are a particularly bad subset of liquidity crises

    1. Edward Harrison Post author

      What I mean is the liquidity solvency dichotomy is like the difference between smoke and fire. The smoke is the liquidity problems and its everywhere, but at heart there is a fire burning. You just have to find it.

      People are panicking for a real reason and its always that way.

      1. Economic Maverick

        That makes sense

        I’ve head some say that Italy is a liquidity issue but not a solvency issue because (as you mention) they are running a primary surplus, and are only in trouble because they have much short term paper to roll over. Wouldn’t that be more of a liquitidy issue? I guess i’m struggling a bit with these terms

  10. The Heretic

    Herr Panzer Kommander Angel Merkel and her French Poodle pet Sarkozy believe that if they protect their god named the Euro and listen to its high priest bankers, and save only the banks but force the people into austerity, then the free market will work its magic, John Galt will arise from the grave, and EU-wide prosperity based on EU-wide trade surpluses will result. Of course we know their hope defies reality and logic. But perhaps we should encourage them along this madness, because the pain of economic depression might wake them from their delusions, or motivate their populations to select more wise leaders.

  11. Paul Walker

    I suspect that when this episode concludes Germany will be able to discuss the effects of both hyper-inflation and hyper-deflation.

  12. Domtex

    Sorry, you will not be taken seriously as a financial commentator if you continue to misspell principal; principle is an entirely different concept!

  13. The-Real-Answer

    For me the real goal remain the (not democratic) creation of the ‘United States of Europe’ (leaded by Germany), period. And Monti is a man from the usual (usual for so many figure in Italy in the last decades) Goldman’s man (and Trilateral and Bilderberg).

Comments are closed.