It appears as though the European sovereign debt crisis is about to claim its next scalp. Yesterday we noted that Silvio Berlusconi gained one vote in parliament due to a parliamentarian falling into a coma, but it seems that at the same time, resistance against Uncle Silvio's rule is growing rapidly among his former supporters. In a flurry of last minute lobbying, Berlusconi has reportedly been busy promising his detractors important government jobs if only they support him one more time.
Berlusconi not only has a fairly high entertainment value for a politician, he is also a wily political operator, who has survived an avalanche of confidence votes this year. At the time of writing, another confidence vote is imminent – and if the market reactions to yesterday's flurry of rumors is anything to go by, it would be better for the euro project if Berlusconi indeed lost the vote this time.
As it were, the sell-off in Italian bonds temporarily reversed yesterday when a rumor surfaced that he was about to retire voluntarily. By the end of the day this rumor had been quashed, and Italian bonds closed at the day's low, with the 10 year yield up another huge 30 basis points, while the yield curve continued to flatten, creeping ever closer to inversion.
Then this little tidbit came to light: Berlusconi and finance minister Giulio Tremonti – the latter the man who has been credited and associated in the mind of the public with the fiscal reforms that have been implemented thus far – gave an interview over the weekend. Apparently by mistake, thinking the microphone wouldn't pick up what he said, Tremonti told Berlusconi: 'Unless you step down by Monday, there's going to be a bloodbath in the markets'. The incident has been .
Tremonti's prediction came true: there indeed was a bloodbath in Italy's bond market on Monday and it continued in early trading today, with yields at first blowing out to 6.744% on the 10-year – a move that has however been reversed again when we last looked (probably the ECB has once again stepped in as a buyer).
The ECB is rumored to be trying to exert pressure on Italy's government by tactically reducing its buying at certain times, so as to show the government what will happen if it doesn't finally implement more austerity. This is of course playing with fire, given the previously discussed haircut rules of LCH Clearnet.
The Pitfalls of The Welfare State
Funny enough, when Berlusconi is telling his colleagues in the eurocracy that Italy is actually doing fine in terms of its debt, he is not too far off the mark. Yes, it sports the second highest public debt-to-GDP ratio in the euro area, but this is partly an artifact of Italy hiding less of its total indebtedness 'off balance sheet'. Italy in fact it looks like a much better credit in the long term than e.g. the US, Germany or France. Furthermore, the private sector in Italy is of exemplary frugality and has little debt and very high savings.
Lastly, Italy is actually expected to produce a primary budget surplus this year. This plan may yet be upset by the gathering economic storm, as the euro area is clearly falling into recession and Italy is among the nations falling the fastest. Nonetheless, it seems almost absurd that Italy has been singled out and that its bonds are now acting worse than those of e.g. Spain. In our opinion, Spain's economic troubles are far worse than Italy's and the probability that it will fail to meet its fiscal targets is extremely high. Still, even Spain still has relatively little public debt compared to the rest of Europe – the problem in its case is rather that the economic depression seems highly likely to sabotage its austerity plans.
Albert Edwards of SocGen has frequently made these points as well, but as usual, it seems few want to listen to him.
As Edwards noted in a recent missive, the fact that the crisis has now begun to center on Italy is most likely Berlusconi's own fault. As readers may recall, we wrote in early July about the growing rift between Berlusconi and the architect of Italy's new fiscal policy, Giulio Tremonti (see 'Italy in the Spotlight' for details).
Contrary to Berlusconi, Tremonti actually enjoys a modicum of credibility. At the time it appeared as though Berlusconi was about to fire Tremonti, whom he doesn't like personally, and who had snubbed a few other politicians with his gruff and direct manner. Tremonti evidently doesn't suffer fools lightly, and consequently has made his share of enemies.
We named the market reaction to this event the 'Tremonti Plunge'. As it were, Albert Edwards also sees this as the decisive moment when Italy began to inexorably slide into crisis mode and began to replace Spain as the main focus of the market in euro-land.
Edwards created the chart you can see below, which compares the public debt of a number of nations, including all on and off balance sheet items.
If one compares both on and off balance sheet debt, Italy actually looks like one of the better sovereign credits out there – click for higher resolution.
In view of the above, it is downright absurd that Merkel, Sarkozy and the eurocrats in Brussels like e.g. Herman van Rompuy are busy berating and ordering Berlusconi around and are now going as far as imposing IMF surveillance on his government.
In fact, if one thinks things properly through, the problem is not so much Italy's current level of public debt, but rather the fact that the country has atrophied economically. It has become uncompetitive as a result of being locked into the euro while concurrently maintaining some of the most restrictive labor market regulations in all of Europe.
For instance, Ambrose Evans-Pritchard at the Telegraph – whose writings are usually highly entertaining and often informative to be sure – keeps demanding that the ECB's printing press be brought to bear to 'solve' the crisis, but in the same breath tells us that it won't help anyway, as the competitiveness problem is not amenable to a solution.
Alas, why should that be the case? Contrary to Pritchard's and others assertion that one should simply blame the euro as such, the blame lies actually elsewhere.
In blaming solely the currency, one is effectively saying: what a pity that no-one can engage in beggar-thy-neighbor type devaluations!
One is in fact asserting that 'beggar thy neighbor' type devaluation policies and the printing press can somehow create wealth. Well, that is unfortunately not true. If it were, we'd already have arrived in Cockaigne and the roasted pigeons would be flying into our mouths unbidden.
As we have said on several occasions, the ECB's 'price level targeting' policy combined with a fractionally reserved banking system has the tendency to produce enormous credit and money supply expansions during boom phases. This is certainly one of the major problems the euro area faces, along with the fact that 'interest rate convergence' of government bond yields when the euro was introduced seduced many governments into borrowing and spending more than they otherwise would have. This combination of factors has produced different rates of monetary inflation and hence economic booms of varying size in the different nations comprising the euro area, with the result that some are now facing much bigger busts than others.
Alas, the uncompetitiveness of e.g. Italy owes not only to the different monetary inflation rates in the euro area nations during the boom, it is also a result of the restrictive anti-free market policies of what is after all a typical European welfare state. As noted above, in Italy's particular case, its labor market is one of the most highly regulated and restricted in all of Europe. This produces a high rate of institutional unemployment and has unnecessarily ratcheted up labor costs. Any attempts at reform have so far been bogged down by the resistance of unions.
It must be stressed that almost all the euro area nations suffer under the yoke of over-regulation and too high taxation – as can be seen in the case of Ireland, its comparatively more pronounced pro free market stance and low taxes have by now managed to bring it back from the brink in spite of the fact that it actually suffered through one of the biggest credit expansion and real estate booms in all of Europe. Obviously, Ireland's success – it is the only EU nation the economy of which is currently showing accelerating growth instead of contraction – has to be due to something. Logic and economic science tell us what this something must be: it can only be what differentiates Ireland from the remainder of the PIIGS stable, namely its low tax regime and less onerous regulatory framework.
The solution is not, as Evans-Pritchard and many others aver, the reintroduction of the possibility of currency devaluation. No-one has yet devalued and printed himself to riches. The solution can also not be the ECB's printing press. The only solution is a dismantling of the vast bureaucratic interventionist State and its thicket of red tape and taxes in favor of an unhampered free market economy.
To this we would note that although Germany's leaders understand that money printing can never be a solution, they do not understand this latter argument. In fact, they are completely tone-deaf on this point, as Angela Merkel's recent adoption of the socialistic position on the question of minimum wages proves. It would be no exaggeration to call European political leaders a bunch of economically illiterate nincompoops. Hence one must continue to fear the worst.
Source: Acting Man
