The Only Two Ways Italy Can be Saved

Immediate problems facing Italy:

  • Unsustainable and dangerously high interest rates on its sovereign debt
  • Very high debt levels – Debt/GDP ratio above 120%
  • Stagnant economic growth and loss of market confidence in Italy’s ability to get its fiscal house in order

Eurozone pundits have speculated about the Eurozone sovereign debt crisis moving to Italy since the very beginning. Italy has always been the “big enchilada” that made doom and gloomers get all warm and fuzzy inside when pondering the implications of its collapse. Today, Italy is front and center and the situation is indeed a very serious one.

To put it bluntly, Italy is not only too big to fail but it is also too big to bail. This leaves one line of defense left – The European Central Bank. A great deal has been made of the ECB’s limited mandate of medium term price stability. The ECB is not a “the lender of last resort” like the US Federal Reserve is – the ECB has the ability to engage in open market operations in order to maximize “the monetary policy transmission mechanism”. However, this does not allow the ECB to engage in open ended quantitative easing operations similar to the Bank of England or the Fed.

It doesn’t take a PHD in economics to understand that interest rates of 7%+ are entirely unsustainable for a country that has stagnant economic growth and a debt pile which amounts to ~120% of GDP. This is no longer fun and games, the situation facing Italy is a very serious one which requires sweeping action not only by Italian fiscal authorities in restoring market confidence that Italy is serious about getting its fiscal house in order, but also by the ECB – Only the ECB has the firepower to suppress bond yields in the short term. The ECB has been engaging in open market bond purchases of Italian paper in an attempt to staunch the blood loss, however, the market is simply too big for much of an impact to be made.

I see two main alternatives which would have a positive market impact, whereas, all other alternatives are likely to lead to a complete Eurozone meltdown. The Eurozone’s two primary positive alternatives:

  • Agree to a comprehensive plan for fiscal integration and agree to issue euro bonds.
  • Change the ECB’s mandate thereby allowing the central bank to become the lender of last resort and expand the primary objective from one of medium term price stability to also include employment and economic growth.

Of course, the conventional wisdom has it that Germany will never agree to euro bonds or allow the ECB’s mandate to be expanded past one of price stability. Therefore, we are left in a precarious situation where it is very difficult to envision a positive outcome for the common currency. Regardless of what anyone says, the ball is ultimately in Germany’s court – The country that has been the focal point of Europe for at least the past century once again holds all the cards.

If you only read one more article on the eurozone today I insist that you read this piece by Cullen Roche which perfectly explains the challenges currently facing the European Monetary Union (EMU):

“I think the EMU will continue to kick the can until they are forced to break out a bazooka of some sort. This means they either implement Eurobonds, Euro TARP or some other measure that leads in the direction of effective fiscal transfers and fiscal union. As is, the EFSF cannot fix the Euro problems and the ECB is unable to control interest rates with their current form of bond buying (they should target rates and not size).” Roche

This is a key concept, rather than embarking upon a program of quantitative easing (which has largely been a failure in the US) the ECB should set a target yield for eurozone sovereign debt or provide a guarantee to that debt. This is the biggest “bazooka” of them all and is sure to throw the Austrian economists and gold standard types into a tizzy but at this point there really isn’t much of a choice.

Also Read: The First Bank of the United States – A Necessary Evil?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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