The rolling crisis has assumed a more urgent dimension as heavy selling of Italian government debt pushed yields beyond the 7 per cent threshold that ultimately proved to be the point of no return for the Greek, Irish and Portuguese sovereigns. The turmoil has been blamed variously on the travails of Silvio Berlusconi, the large outstanding stock of government debt versus annual economic output and the economy’s low prospective growth rate. These factors have been known for a considerable time, however, and, if truth be told, the malaise was precipitated by the steps taken by Europe’s leadership in Brussels last month, which were designed to ease the growing stress. The measures backfired spectacularly as the facts of economic life in a poorly constructed monetary union became clear for all to see. The truth is that debt issued by a government in a currency that it does not control should never be considered free of default risk and, in this regard, euro zone members are not that far removed from emerging countries that are forced to issue bonds in a foreign currency. This harsh reality has finally dawned on the bond community and, as the pre-crisis assumption is discarded completely and credit risk continues to be discounted in government debt prices across the euro zone, it becomes ever clearer that the only solution to the immediate crisis rests with the European Central Bank. In order to prevent the liquidity crisis from degenerating into a solvency problem, the central bank must make a credible commitment to employ its balance sheet and purchase the debt of troubled sovereigns in whatever size proves necessary. Until recently, the threat of a solvency issue emerging in Italy was considered small, as the economy does not suffer from the major imbalances that were so evident in the periphery and possesses important strengths that should have kept the wolves from its door. These included a small primary fiscal surplus, a relatively long average life on outstanding government debt, relatively conservative non-financial private sector balance sheets and a relatively low level of external debt. These strengths counted for nothing, however, once Europe’s leadership announced that the rules of the game had changed, which not surprisingly precipitated a wave of selling across the region’s sovereign debt markets. First, the large size of the haircut – 50 per cent – pertaining to the private sector holdings of Greek government debt, which is considered by most analysts to be nowhere near sufficient to yield a sustainable public debt position, revealed to investors that credit risk is very real indeed, with losses expected by some to be in the region of 90 per cent. Second, the decision to exempt official financing from the write-downs sparked the realisation that all credit losses in the event of future write-downs on troubled sovereign debt would in all likelihood fall in their entirety on the remaining private sector investors – in other words, larger losses for fewer investors. Finally, the large write-down of Greek debt was designed so as not to trigger credit default swap contracts and, as a result, investors cannot expect such insurance to pay out should further sovereign defaults occur. The yields on Italian sovereign debt have dropped below 7 per cent for now as a result of ECB purchases but the lukewarm nature of the buying means that investors cannot be sure how long it will be before the threshold is tested again. Indeed, media reports suggest that heavy bank selling is in the pipeline and, should yields surge higher in response to the liquidation, the less attractive Italian debt will become as the probability of default grows. It is not difficult to envisage a scenario in which insolvency becomes self-fulfilling. Higher interest rates and the related market stress could plunge the economy into a sharp recession with an attendant increase in the budget deficit and the government’s financing requirement, which could precipitate a further increase in yields and so on. To prevent such a death spiral from developing, it is absolutely essential that the ECB commits its balance sheet. However, the monetary authority continues to object to such action on a number of fronts. First, it is argued that an expansion of the central bank’s balance sheet would lead to inflation. However, an increase in the monetary base – currency and bank deposits held at the central bank – does not automatically translate to a concomitant increase in the money supply. Indeed, the traditional money multiplier breaks down at times of crisis due to an increase in liquidity preference. Furthermore, the level of deposits held by banks at the central bank has little bearing on the credit decision, which is determined by capital adequacy and the availability of profitable lending opportunities. European banks already have a capital shortfall of €106 billion according to official estimates and a credible commitment to purchase government debt may not only ease the stress on troubled sovereigns but may also forestall a credit crunch. Second, the aggressive purchase of Italian government debt would see the ECB assume the risk of default on its own balance sheet and, should a restructuring occur, its capital base could well be wiped out. However, inaction could have even more dire consequences, as an Italian default would almost certainly unleash the mother of all banking crises and a deep recession that could tear the monetary union apart. The euro zone crisis has reached a dangerous phase, as Italy stands on the brink. The ECB must act forcefully and act now. The clock is ticking.
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