Bill Emmott - International Author & Adviser

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Italy´s financial woes: it´s bonds and bailouts, not just Berlusconi
The Times - July 18th 2011

It is tempting to blame Silvio Berlusconi for the way in which Italy has found itself in the financial markets’ gunsights, and like the country’s prime minister himself, I follow the Wildean dictum: I can resist anything except temptation. Yet for once, to blame Mr Berlusconi would not be entirely fair. Two other larger and more lasting issues are also to blame.

            For sure, Mr Berlusconi’s failure, ever since he entered politics in 1994, to carry out his promise to bring liberal reform to Italy, is a big reason why the euro’s third-largest economy is vulnerable to a sovereign debt crisis. Its growth has been anaemic: over the past ten years its GDP has increased by less than 3% in all, whereas France’s has grown by 12%. Meanwhile, its public debt is the same percentage of GDP today as it was in 1995: 120%, the eurozone’s second largest after Greece.

            The result is that Italy is vulnerable to any rise in the government’s borrowing costs. This is despite the fact that, since 2008, the finance minister, Giulio Tremonti, has succeeded in over-ruling his boss’s spendthrift instincts and has run one of the tightest fiscal policies in the euro zone, with a budget deficit this year less than half the size of Britain’s.

            For all that good behaviour, an analysis by Unicredit, Italy’s largest bank, shows that, in the absence of faster economic growth, it would take just a two percentage point rise in the government’s average borrowing costs to make the public debt level head in the Greek direction. That is just what has been happening. About half of Italy’s debt is financed domestically, being bought by banks, insurance companies and households, which offers some comfort, but that still means the other half of a 1.5 trillion euro stock of debt is held by flightier and more demanding international investors.

            News that Mr Berlusconi was trying to get rid of his only internationally respected cabinet minister, the said Mr Tremonti, and had made public his preference for new tax cuts over the fresh austerity budget being put forward by him was bound to roil the markets.

            It was typically irresponsible, and it is with typical chutzpah that the prime minister has now reversed position and called for national unity over the budget. That unity has prevailed, and the budget has been passed. But there is still plenty of room for doubt in the markets, given that even on Mr Tremonti’s plans, four-fifths of the cuts are deferred until 2013 and 2014. Perhaps he has been reading Ed Balls’s speeches.

            Typical is the apt word, however: Italians are quite used to Mr Berlusconi’s behaviour. But something else is starting to feel typical too, and it is coming not from Italy but from the governments of the northern European eurozone members that these days call the shots, especially Germany.

            This is a continued disregard both of  the reality of the debt situation in the eurozone, and of the consequences for other eurozone members of actions taken or contemplated for one of its members. It is odd: this is a common currency, with a common monetary policy, and yet Germany is behaving as if each country within the euro can be treated as if it were separate. The reason is that the consequences of accepting that this is a collective problem are both economically and politically explosive.

            Germany is creeping towards one right conclusion: that Greece, for all its undoubted efforts to cut its public spending and raise more tax revenues, is insolvent. It cannot afford to service its debts at their current level of 150% of GDP, and the austerity packages are making those debts less affordable, not more. So a way needs to be found to reduce the debt burden, just as had to be done in Latin America during the 1980s. Lenders have to write off part of the value of the debts, and those lenders include German and French banks as well as the European Central Bank, none of whom are happy about the fact.

            The new realism that debt relief is necessary does count as progress. But to pretend that it can be done just for Greece is a delusion. Worse, it is a delusion with consequences, which were seen in the past week’s sell-off of Spanish, Italian and for a while even French government bonds. If Greece is to get debt relief, after all, why shouldn’t other governments ask for it too? And even if they say they wouldn’t, bond markets are going to bet that some of them would, just in case. That is the question that needs to be answered at the eurozone’s latest emergency summit, on July 21st.

            The only way out of a collective, broadly applied write-down of eurozone government debt, with all the losses it would cause to banks, insurance firms and pension funds, and all the potential for chaos in debt-insurance markets, is to make the treatment of Greece so different from that of the others as to convince markets that they will not follow.

            Short of the, presumably unfeasible, political annexation of Greece by Germany or by the European Commission, this has to mean ejection from the euro, which though it would bring a devaluation would probably also exclude Greece from borrowing from the financial markets for several years to come. That is a ghastly prospect for Europe, and would still invite speculation about other ejections. But it would concentrate governments’ minds.

            The alternative, a collective write-down of eurozone government debt, brings in the second, larger and potentially long-lasting issue which is becoming steadily more manifest. It is that government bonds are moving from being supposedly safe havens, a dependable financial asset that deserves the name “gilts”, to becoming among the riskiest.

            That is what defaults and debt restructurings mean. Governments would like to pretend otherwise, which is why they excluded sovereign debt from their initial “stress tests” on European banks last year, for how could a safe asset be stressful? When governments decide to default on it, that’s when. The latest stress tests, released on Friday, showed a good pass rate also because the risk of debt defaults was played down.

            Yet at the same time, governments are trying to force or at least incentivise their financial institutions to hold more and more government bonds by introducing regulations that require far less capital to be held by banks as backing for gilts, and that demand that insurance firms hold a certain portion of their assets in this form.

            The origins of this lie in the tendency of regulators and politicians to fight the last war rather than the next one. They are dealing with the previous sort of risky behaviour rather than the current one. The consequences, however, could be with us for a long time. Our main repositories of savings are being made to lend more to governments and less to companies. Such financial repression, as bankers call it, is not exactly a recipe for rapid economic growth.

           


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