The Italian Job

By Eoin Fahy, Thursday, 14th July 2011 | 0 comments

Yet again the main focus of the financial markets over the last week has been on the eurozone sovereign debt crisis, with attention this time turning to the sudden sell-off of Italian bonds and the truly frightening possibility emerging that Italy might not be able to borrow on the financial markets.  European authorities find themselves - again - faced with the need to take radical and effective action to reduce financial markets worries. Fast!

It’s very hard to know why Italy recently found itself so suddenly in the firing line.  It may be because a new austerity package announced last week postponed most hard decisions until after the next general election.  Confidence was further damaged by the discovery of an obscure clause in the rescue package that appeared to be designed to allow Prime Minister Berlusconi’s own company to avoid paying a very large compensation bill as a result of bribing a judge in a major court case some years ago, and by the heavy losses the PM’s party has taken in recent local and regional elections.  None of these issues seemed hugely significant on their own, but they came together to result in a loss of confidence in Italy and its government.

If that loss of confidence leads to an inability of Italy to raise debt on the financial markets, it is truly a “big deal”.  For comparison,  Ireland needed a rescue package of €68bn, and has less than €100bn in total government bonds outstanding.  Italy, however, has total government debt of close to €2000bn!  Even for large economies like Germany and France, there is no chance that they could fund a rescue for a country as large as Italy.  The “rescue fund” put in place by the EU and IMF was designed, in practice, to be  big enough to cope with problems in Greece, Ireland, Portugal and Spain.  It was never supposed to be large enough to rescue Italy, and frankly it never could be.

Faced with a problem this size, perhaps the good news is precisely that the problem is so large.  The existing bail-out arrangements for Greece, Ireland and Portugal have not worked at all well, at least in terms of reassuring markets that the problems in each country can be solved and they can return to borrowing as normal from the financial markets in the not too distant future.  However, if Italy was similar in size to Greece and Ireland, the chances are that the EU authorities would try to apply the same (failed?) solution to them. 

But since Italy is so large, the EU will have to try a much more radical approach, if Italy does get into real trouble, which of course is not a foregone conclusion.  Will EU leaders seek assistance from the US and China?  Will the ECB cave in, throw all its principles to the wind, and simply ‘print money’ to rescue Italy?  Will there be a deal whereby the EU itself raises money from the bond markets and then gives it to the countries in difficulties?  Will countries be allowed to use their rescue funds to buy back their own bonds at a large discount?

All seem unlikely, but if Italy gets into difficulties, some radical solution like one of these will have to be found.  The world economy could not begin to cope with a  default on €2000bn of Italian government debt.

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