More thoughts on the Euro crisis: a tale of two sick countries

They’re the two weakest economies in the G7. But only one of them is under fire.
One is on the cross-hairs. The other not quite.

One is on the cross-hairs. The other not quite.

In my previous post, I tried to explain why a Greek collapse (be this in the form of a default or a Euro exit) should not be such a catastrophe to anyone except for the Greeks themselves. The cost of recapitalizing exposed banks would be a fraction of the money spent rescuing the banking system in 2008, and the financial and trade linkages with Greece and the rest of the Eurozone are so meagre that the common currency area should be strong enough to resist one of its weakest members going bust. But of course, that is not the scenario that keeps European politicians awake at night these days. That is Because although a Greek default may appear to be a disaster, a default among one of the Eurozone’s bigger economies – mainly Spain and France – would be economic Armageddon. A scenario like this would dwarf even Lehman’s bankruptcy in the scale of devastation it would unleash upon the global economy, particularly now that governments in the West are too weak to undertake bank bailouts and fiscal stimulus packages like they did back in 2008-09.

But this leads me to the second part of my argument: even the doomsday scenario of an Italian collapse doesn’t hold up to the reality of its economic fundamentals. I’m not saying this means it could never happen. Quite the contrary: if markets believe it will happen, it will happen, all that is needed is to get enough market aversion to Italian debt that Italy’s bond yields are pushed to unsustainable levels. But why should markets believe it? And more importantly, why didn’t markets believe this during the first year of the Euro crisis, when Italian bond yields had been left practically untouched? What has changed during this time?

The answer, quite simply, is nothing.

Is the sick man of Europe really that sick?

Italian bonds have always been perceived as riskier than those of its big European peers. This is largely because Italy has been, over the past two decades, the most heavily indebted of all the large European economies. Already by the year 2000, Italian public debt had exceeded 100% of GDP, well above the 60% threshold which has been established as the maximum acceptable level for Eurozone members. Of course, at the time there appeared to be little reason to worry: despite its lethargic growth, it was a stable country, capable of financing much of that debt domestically, and its deficit levels appeared manageable. During the “boom years” of 2003-08, the average Italian fiscal deficit was 3.2% of GDP, the same as France’s, and better than the UK, US or Japan. Other key economic indicators also pointed out to relatively healthy fundamentals. Italy’s current account deficit averaged 2% of GDP during the same period, better than the UK, US and Spain. And its unemployment level was 7.3%, lower than the other “state-heavy” economies in the region such as France and Germany. But as I mentioned earlier, where Italy was flagging behind was GDP growth: just 0.7% on average during the boom years (which can hardly be called such in Italy’s case). This was the lowest among the G7, and even the lowest among the so-called PIIGS.

The big myth being perpetrated by the behaviour of markets is that Italy’s fiscal situation has since turned unsustainable. As such, markets have begun pricing the possibility of an Italian default by demanding higher yields on Italian public debt. But in reality, among Europe’s big economies, Italy was the one to indebt itself less during the global crisis. Between 2007 and 2010, its total gross debt as a percentage of GDP went up by a paltry one-seventh. In stark contrast, Britain’s debt went up by nearly three-fourths thanks to the huge scale of bank bailouts. Even the wirtschaftswundermenschen (I just made up this word), the Germans, saw their debt go up by nearly one-third. So it’s certainly not the level of debt itself that has suddenly turned unsustainable, given that it’s been so high for so long, and a country that has had such high debt for such a long period of time is surely able to cope. In other words, budgets have already adjusted to the higher debt burden and there is no need for dramatic adjustments to spending (i.e. massive austerity measures) or increases in revenue through unpopular policies such as tax increases.

The counterargument to this is that Italy is in trouble not because it got excessively indebted during the crisis or because its debt was so high in the first place, but rather that its debt dynamics have gone sour due to its low long-term growth prospects. Now, I have to partly agree with this. I’m certainly no fan of Mr Berlusconi’s economic management, and the fact is that Italy’s economic record as a whole for the past three decades cannot be described as anything other than mediocre (believe it or not, in 1990 Italy’s GDP per capita was actually higher than Britain’s). The 0.7% growth rate during the boom years is proof enough that Italy’s economy faces severe structural problems which need to be addressed. But is this enough to justify the sudden rise in Italian bond yields? Having hovered around the 4% mark for the better part of the decade, Italian bonds first rose to around 5% as the Euro crisis deepened towards the end of 2010, and then skyrocketed to 6% in July, after political bickering over Greece’s second planned bailout raised market fears over the sustainability of Italy’s debt. From having escaped the crosshairs of the bond market during the first few months of the Euro crisis, Italy was now on the front lines: 7% is generally believed to be the threshold after which a country’s debt costs become unsustainable and a default inevitably follows.

Turning Japanese (pun intended)

I have one word to debunk this claim: Japan. Japan’s debt as a percentage of GDP is almost twice that of Italy’s (over 230% of GDP, the highest in the world); its currency has appreciated enormously over the past year hurting its most competitive sector, manufacturing; it has suffered a devastating earthquake, tsunami and nuclear meltdown; and although its prime ministers are not known for their bunga-bunga parties, Japan has arguably the most chaotic and unstable political system among the G7. Primer Minister Yoshikiko Noda who came to power early this month has the unenviable honor of being the sixth new prime minister in five years. Among the G7 countries, Japan is the country which remains farthest from returning to its pre-crisis peak in terms of GDP. And Japan’s long term growth prospects are hardly better than Italy’s: its population is older, there’s less scope for immigration to make up for its demographic decline, and it is not part of any supra-national body like the EU which in an unlikely but hopeful scenario could encourage greater structural change. Suddenly Italy doesn’t look so bad, does it? Here’s another kicker: according to IMF figures which more or less converge on the consensus, the Italian economy is expected to grow by a miserable 0.8% average during 2011-16. That’s actually a bit more than the 0.7% average growth during the “boom years” of 2003-08. Stop the press: Italy might actually grow faster than the before the crisis!

But yet this is the reality: Japan’s 10-year bonds are trading at just 1% as I write this. US treasuries are trading at 2.2% and UK gilts at 2.5%; less than half of the 5.9% charged for Italy’s and a fraction of the murderous 25% slapped on Greek debt. Although it is true that inflation expectations also influence bond prices, even when accounting for this factor, the differences between Japan and Italy’s rates are enormous. According to the IMF’s forecasts for 2011-16, Japanese inflation will average 0.2% which points towards a “real” bond yield of 0.8%. Italian inflation will average 1.9%, which results in a real yield of 4%. To quote the great Mugatu from Zoolander: I feel like I’m taking crazy pills!

Once the effects of the crazy pills have subsided, my third and last post on the Euro crisis will deal with the market logic of turning a small country default into potentially the biggest economic Armageddon in the history of capitalism. Stay tuned.

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