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Why Italy’s Days in the Eurozone May Be Numbered

From the Financial Times:

With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of €1,900bn. That would partially address its “stock” problem of large and unsustainable debt but it would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

So Italy and other illiquid, but solvent, sovereigns need a “big bazooka” to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.

One is urgently needed now. Eurobonds are out of the question as Germany is against them and they would require a change in treaties that would take years to approve. Quadrupling the eurozone bailout fund from €440bn to €2,000bn is a political non-starter in Germany and the “core” countries. The European Central Bank could do the dirty job of backstopping Italy and Spain, but it does not want to do it as it would take a huge credit risk. It also cannot do it, as unlimited support of these countries would be obviously illegal and against the treaty no-bailout clause.

Thus, since half of the European financial stability facility’s resources are already committed to Greece, Ireland, Portugal and to their banks, there is only about €200bn left for Italy and Spain. Attempts have been made to use financial engineering to turn this small sum into €2,000bn. But the leveraged EFSF is a turkey that will not fly, because the original EFSF was already a giant collateralised debt obligation, where a bunch of dodgy, sub-triple-A sovereigns try to achieve, by miracle, a triple-A rating via bilateral guarantees. So a leveraged EFSF is a giant CDO squared that will not work and will not reduce spreads to sustainable levels. The other “turkey” concocted by the EFSF was supposed to be a special purpose vehicle where reserves of central banks become the equity tranche that allows sovereign wealth funds and the Bric countries to inject resources in a triple-A super senior tranche. Does this sound like a giant sub-prime CDO scam? Yes, it does. This is why it was vetoed by the Bundesbank.

So, since the levered EFSF and the EFSF SPV will not fly – and there is not enough International Monetary Fund money to rescue Italy and/or Spain – the spreads for Italian debt have reached a point of no return.

After a patchwork of lending facilities are cobbled together, and found wanting by the markets, the only option will be a coercive but orderly restructuring of the country’s debt. Even a change in Italian government to a coalition headed by a respected technocrat will not change the fundamental problem – that spreads have reached a tipping point, that output is free-falling and that, given a debt to GDP ratio of 120 per cent, Italy needs a primary surplus of over 5 per cent of GDP just to prevent its debt from blowing up.

Output now is in a vicious free fall. More austerity and reforms – that are necessary for medium-term sustainability – will make this recession worse. Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable.

Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness . That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts.

The eurozone can survive with the debt restructuring and exit of a small country such as Greece or Portugal. But if Italy and/or Spain were to restructure and exit this would effectively be a break-up of the currency union. Unfortunately this slow-motion train wreck is now increasingly likely.

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster.

The writer is chairman of Roubini Global Economics, professor at the Stern School at New York University and co-author of ‘Crisis Economics’

58 Responses to “Why Italy’s Days in the Eurozone May Be Numbered”

laprimerafuenteNovember 10th, 2011 at 7:01 pm

España tiene una deuda en relación al pib tan sólo del 60%, y el valor absoluto que paga por los intereses de su deuda es inferior al de países como Francia o Alemania. No estoy de acuerdo con sus comentarios en relación con la economía española.

dpedramNovember 10th, 2011 at 7:31 pm

True that Spain is in a better spot but there is significant gap between the productivity in south European countries and nordic countries which impedes them from showing strong growth, which, if I am not mistaken, makes the long term servicing of debt difficult. So the problem is not current debt but future growth.

I am curious if Mr Roubini believes this restructuring can be addressed within the next 5 years? Since the scenario he provides is unlikely, what would this disaster look like in Europe (not just Italy)

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Valli_GenevieveNovember 11th, 2011 at 4:39 pm

So, I have been fascinated by the news that when Italy's interest rate for borrowing additional funds went to 7%, it was considered "unsustainable", the "tipping point" yet the average American consumer is expected to carry credit card interest rates of 8-29% and students carry federal student loan interest rates of 7.9% and much higher for private loans. All this while banks can borrow money at essentially 0%. Why is 7% unsustainable for a country but not for a consumer?

At least in America, jobs are not being created and the economy is continuing to fail because consumers are tapped out. If all fixed mortgages went to 3.5%, interest on student loans (education being a public good) was fixed at 2% and credit card debt were fixed at 5%, would not that put money in the public's pocket to spend while still providing a small profit for banks?

RamonNovember 12th, 2011 at 10:12 am

Even if Germany decides to pay all the debt of Greece, Portugal, Spain, Italy and Belgium in 10 years we will be in the same position. How quickly we forgot the competitive devaluations of these countries in the last 100 years!

The big difcerence now is that these countries have to compete with countries in Asia, Eastern Europe, Latin America and they have not invested wisely in education and real R&D. Shame on them.

The best advice to the popularion of these countries is to start thinking of emigrating. This EU malaise is going to make the Japanese Lost Decade look like a weekend in the forest!

jctergalNovember 12th, 2011 at 12:49 pm

Germany has defaulted 3 times within the 20th century (1930s, 1953 & 1990), while for instance Greece none in the previous century.

Why a country, which had never defaulted for more than 100 years, despite 8 wars (2 of them civil wars), 2 national disasters (Nazi occupation), a 3.5 mil. population exchange, 2 dictatorships and a huge wave of emigration, it has defaulted now.

How most countries heading to a default are developed and in the eurozone?

The difference is the structure of the eurozone.

Before entering the eurozone in 1997 Italy had a current account surplus of 3% of GDP. In the same year Greece had a -3% current account deficit. In 1993 Italy was the 4th largest economy of the world (surpassing France & the UK) and Greece had a 0% current account deficit.

Let's see what happened after the entrance in the eurozone.

In 2008 Greece had a -16.5% current account deficit and Italy -3%. That is a -12% difference for Greece and a -6% for Italy.

In other words, it seems that both Italy and Greece should have never participated in a zone with much more competitive economies, such as Germany or the Netherlands or they should have transformed their economies first before entering.

Meanwhile, in the 1990s (outside the eurozone) Germany increased its exports by around 40% (around 3% per year), while within the eurozone despite the crisis of 2008 its exports increased 115% (!).

The eurozone:
- Increased differences in competitveness
- Hugely exacerbated current account deficits for less competitive economies, while propagating current account surpluses for countries like Germany or the Netherlands
- Deprived most nations from fiscal tools for correcting such imbalances (such as money printing or devaluing the currency)

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wiserguy1971November 15th, 2011 at 4:08 am

Nice piece, though this time you completely miss the point, imho.

I was born and grew up in Italy, moved to the US 8 years ago after getting my PhD, so I know Italy very well.

Unlike the rest of PIIGS, Italy has many great, successful companies (on too of a BEAUTIFUL country): Made in Italy (not Greece, or Portugal, no offense people) still means great quality and top of the line in many different sectors, NOT only fashion. That explains a large, $2,2 trillion economy.

The PROBLEM with Italy is that too many Italians do NOT pay taxes; out of 41 million taxpayers, 13 million declare 0, 14 million between 10,000 and 20,000 euros AND (the cherry on the pie) ONY 796 people declare 1 million euros or more, not 796 thousands!!!

How can it possibly be that in a country with such a rich economy 2/3 of people are "poor" (living with less than 20,000 euros) and there are virtually no millionaires? It just makes no sense.

What Berlusclown (aka Burlseque-oni) did to make things worse is to remove property taxes from the first house; with this retarded fiscal policy those people who have their own business and DO NOT PAY income taxes, can now live in our beautiful country free of charge, services provided by those citizens who simply cannot hide their income (such as my mom a University Professor).

What Berlusclown should have done (and hope Monti will do) is to FIRST of all raise immediately property taxes by 20 times and at the same time reduce income taxes: if it is way too easy to hide your income if you have your own business (dentist, restaurant, plumber, electrician, whatever), you simply cannot hide a house.

Second, long-term, check how those 13+14 million poor people live and TRUST me you will be surprised to find out that probably 2/3 of them are actually pretty well off.

You don't need a PhD in economics to understand that you simply cannot provide 55 million people with good affordable health care, good affordable education, pensions for 30-40 years, etc, etc, etc while ONLY 14 million people pay 100% of their taxes, math is unfortunately inexorable.

If you get a chance, please pass my suggestion along to Monti, he needs all the help possible.
Best regards,

jctergalNovember 15th, 2011 at 7:44 am

wiserguy1971.

You differentiate yourself from other southern economies (and it is in part correct, Italy is worldwide leader in luxury cars more than 200.000 euros, is strong in yacht manufacturing, 1st in olive oil exports, 1st in wine exports (volume) etc).

And you say the same things a Greek would say. A… you know the politicians … we don't pay taxes .. etc

What has changed from the 90s where Italy was the 4th economy in the world with significant surpluses.

- Were the politicians better then?
- Did people pay their taxes?
- Weren't there "lazy" employees in the public sector? (probably more than now)

One thing has changed the euro. The euro transformed surprlus countries (like Italy) to deficit countries, while transforming marginally deficit countries (like Greece, Portugal) to states with huge deficits that lead directly to bankruptcy.

Of course Greek manufacturing is no match to Italy. But, still Greek shipping sector is the 1st in the world (more than 20% of worldwide capacity). Greece is one of the few countries with almost 2 tourist arrivals per capita per year. 3rd in the world in olive oil production.

That is more than enough for a country of 10 million. But that's not enough for a country in the eurozone.

wiserguy1971November 15th, 2011 at 1:53 pm

@jctergal

You raise a good point:

- Were the politicians better then?
- Did people pay their taxes?
- Weren't there "lazy" employees in the public sector? (probably more than now)

Nothing has changed, politicians globally are NOT serving their citizens BUT companies and lobbying groups that put them in power, they are old, ignorant, completely out of the global economy etc etc etc.

See how many politicians can speak a foreign language are are simply capable of turning on a computer, let alone know social network is, and especially so in souther Europe.

Tax evasion as far as Italy goes, was and still is too high to make any financial sense. And public employees are still as lazy as usual.

Take this article with a big pinch of salt BUT facts, if different, are probably NOT all that different: http://www.businessinsider.com/greece-germany-pen…

The #1 problem for several countries, and especially so Italy and Greece, is that we don't have enough young people working to support those who don't anymore.

If you add to it the increasing cost of health are due to novel, effective (not always) and most importantly EXPENSIVE, therapeutic approaches (that is my field by the way), here you have it a recipe for disaster.

The USA where I live and work are facing themselves a huge problem due to out-of-control health care spending.

Finally what all Western countries need to do is how the hell do we grow our economies?!?!?!!? The talk is all about austerity and cuts: tell me how this is going to lead to jobs and growth?!?!?!?!?

If you jctergal have accumulated debts and then out of a sudden you lose your job, tightening your belt might help BUT unless you find a job and fast, you are going to go bankrupt, numbers are numbers.

So explain to me how in economies that are by en large supported by consumer spending, austerity is the solution?!?!?!?!?

Makes no sense, and it sadden me deeply.

I love Greece, been there many times, and to think that the same country where "democracy" was born is facing this, is just a shame.

Best of luck,
Guy

mifainaNovember 15th, 2011 at 2:03 pm

"So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts"
So, are you saying basically to "float" the new lira and inevitably let it sink vs. the euro? Will not something like this trigger a run at the banks mostly affordable for the rich while the poor will see their little savings going down and not be able to do anything? If at first phase 1 lira = 1 euro and then lira sinks to let's ay 1 euro = 10 lira most likely the prices and salaries will not remain the same as they were before this forced conversion. So the Italians will be on the same with Chinese when their "rich neighbors" will by their products for less and pay their debts by working for less, what basically euro zone does for ALL the other countries except France and Germany? I

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jctergalNovember 16th, 2011 at 7:43 am

I agree on the part of the ineffectiveness of austerity measures.

I also agree it is a shame. Especially for a country withstanding so many hardships successfully (wars) to be in such a position today, as a eurozone member.

Greece is a small and weak country, with leaders often serving foreign and not national interests. It is also a country with less than 200 years of history (less than 100 in its present form) which emerged from the Ottoman Empire.

Nonetheless, it became the most advanced economy among ex-Ottoman nations. You cannot easily expect than an ex-Ottoman province would be able to be in the same levels as countries with centuries of successful economics such as the Netherlands.

Personally, I expected that Greece would not be competitive inside the eurozone.

For me, it is much more surprising that a country:

- 4th largest economy in the world during the early 1990s
- 3rd largest in the eurozone now
- With strong worldwide presence in many sectors (such as food & beverage, furniture, fashion, production design, automobiles (especially luxury ones), yachts etc)

like Italy to have such financial issues.

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Natali_78June 18th, 2012 at 6:44 am

This financial crisis is just killing Europe.At least now it's sad to see the way all the strong countries with economy,that was stable enough, more and more get in financial problems and make one debt after another.On one hand- this debts and tranches from the European government can really save such Greece and Spain, on other hand – this countries are getting more into the debt, and as we know, paying off the old debt with making a new one do not solve the problem.Italy also has rising soveregn debt,but nobody can be sure that money advance will help it to to stay in the Eurozone.To my mind,getting back to a national currency can be really an effective option for Italy,this question is just a matter of time.

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