Europe has lit the fuse on an economic and financial bomb. The rescue package for Spain cannot plausibly be contained to €100bn once it begins, given the subordination of private creditors and collapse of global confidence in the governing structure of monetary union.
Italy must guarantee 22pc of the bail-out funds, even though it cannot raise money itself at a sustainable rate. You could hardly design a surer way to pull Italy into the fire.
Citigroup warned over the weekend that Italy’s economy will shrink by 2.5pc this year and another 2pc next year as the fiscal squeeze starts in earnest, with grim implications for debt dynamics. Public debt will jump from 121pc of GDP to 137pc by 2014.
“The situation could rapidly become critical, because the country is highly vulnerable if the sovereign debt crisis persists or intensifies. A significant further rise in yields would deepen and extend the recession and accelerate the rise in the debt/GDP ratio, triggering a worsening vicious circle. We expect that Italy will have to request help,” it said.
The world is uncomfortably close to a 1931 moment. Italy’s public debt is the world’s third largest after the US and Japan at €1.9 trillion. There is no margin for political error.
The EU machinery (EFSF/ESM) exists largely on paper, a €500bn declaration of intent. It had trouble raising trivial sums last year to fund Irish and Portuguese loan tranches — understandably so, since the fund is a transparent attempt to evade the imperative of Eurobonds and EMU debt pooling.
China’s sovereign wealth fund said last week that it was withdrawing from Europe’s debt markets, fearing a collapse of the euro. Investors are willing to pay zero rates for German sovereign debt, or near zero for French debt, sure that these nations will emerge from the rubble come what may. They patently do not want mangled guarantees from an EMU club at risk of disintegration. Sovereignty is all that counts now.
There are many layers of blame for what has happened, but the German policy elites and the European Central Bank are entirely responsible for the latest catastrophic turn of events. They pushed southern Europe over a cliff.
Misjudged monetary tightening by the ECB last year in response to an oil supply shock incubated the double-dip slump now becoming apparent.
All key measures of the money supply in Spain and Italy went into violent contraction in the second half of 2011, with predictable consequences a few months later. The shock was so severe that money contraction had even spread to much of the core by the early winter.
This occurred at a time when banks — under threat of nationalization — were slashing balance sheets to meet the EU’s demand for core Tier I capital ratios of 9pc.
As we now know from the Bank for International Settlements, Europe’s banks went into overkill. They accounted for most of the $800bn fall in cross-border lending in the fourth quarter of 2011. By all means impose higher capital ratios, but not in a depression and not by slashing loans.
Just to ensure that every lever of the EU policy machinery was set on maximum destruction, Germany imposed scorched-earth fiscal austerity as well. Spain must tighten by 4.5pc of GDP this year though unemployment has surged to 24.4pc — from 7.9pc in 2008 — and the public sector is not unduly large. Italy must tighten 3.5pc this year, though it is near primary budget surplus. There is no credible economic theory to justify this pace of tightening. It is beyond any known therapeutic dose.
We hear much talk from the ECB over the need to separate monetary and fiscal policy. Yet the ECB itself was the enforcer of fiscal cuts in southern Europe, dictating terms to Spanish and Italian leaders in secret letters in August 2011. Frankfurt switched bond purchases on and off to secure compliance. Italy’s Silvio Berlusconi was toppled by an ECB-orchestrated Putsch after he dragged his feet.
Some separation. One might suggest that bureaucrats should not take it upon themselves to force sovereign democracies to their knees. The sorry episode cries out for hearings in the parliaments of Europe’s historic nation states.
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