The repeated waves of fresh crisis and temporary hope in Europe are starting to look a lot like the Hokey Pokey. Last week, Italy briefly put its right foot in. Then, thanks to purchases of Italian debt by the European Central Bank, it put its right foot out. Meanwhile, everyone is calling on Germany to turn itself around, and Greece is still just shaking all about. Until last week, much of the concern about European debt focused on relatively small countries with high debt/GDP ratios. In particular, Greece, Ireland and Portugal have debt/GDP ratios of 166%, 109%, and 106%, respectively. But Italy actually comes in at 121% debt/GDP, the highest of any European nation next to Greece. Far worse, Italy has a GDP that is 7 times the size of Greece, and is 3 times the size of Greece, Ireland and Portugal combined. So Italy's debt is not just huge relative to its own economy - it is just plain huge, at about $2.5 trillion in dollar terms. This is a terrible problem for France, whose banks are the largest single creditor to Italy, holding Italian debt worth about one-fifth of Italian GDP.
With Italian yields pushing past 6% and briefly passing 7% last week, Italy is actually very much in the situation that Greece was in about 18 months ago, when it was hoped that new "austerity" measures would shrink the deficit by forcing painful cuts in government spending. They didn't. The effect of austerity policies in weak economies is generally to damage the economy even more, causing a significant shortfall in tax revenues, so deficits don't materially improve despite the reduced spending.
As I noted more than a year ago in Violating the No-Ponzi Condition :
"The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future). Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event."
While present plans to "leverage" the European Financial Stability Facility (EFSF) has allowed attention to deviate from Greece, the fact is that the EFSF has already had problems issuing bonds - having to pay unexpectedly high spreads just to secure a few billion euros of debt, much less tens or hundreds of billions of euros. Meanwhile, the planned 50% haircut on Greek debt does not include "official" debt to the IMF and ECB, which as I noted last week, contributes to the question of whether the 50% figure will actually hold up (particularly given that Greek debt at every maturity is already trading at a 38 handle or less, and the 1-year yield is now up to a record 220%).
If the problem broadens to Italy (and mathematically, we suspect it will because Italy's debt now also violates the no-Ponzi condition), the implications are very unpleasant. Given leverage ratios of more than 40-to-1 for most European banks, there is no way to meaningfully restructure Italian debt without wiping out the capital base of Europe's banks, and forcing the nationalization of the entire European banking system.
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With Italian yields pushing past 6% and briefly passing 7% last week, Italy is actually very much in the situation that Greece was in about 18 months ago, when it was hoped that new "austerity" measures would shrink the deficit by forcing painful cuts in government spending. They didn't. The effect of austerity policies in weak economies is generally to damage the economy even more, causing a significant shortfall in tax revenues, so deficits don't materially improve despite the reduced spending.
As I noted more than a year ago in Violating the No-Ponzi Condition :
"The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future). Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event."
While present plans to "leverage" the European Financial Stability Facility (EFSF) has allowed attention to deviate from Greece, the fact is that the EFSF has already had problems issuing bonds - having to pay unexpectedly high spreads just to secure a few billion euros of debt, much less tens or hundreds of billions of euros. Meanwhile, the planned 50% haircut on Greek debt does not include "official" debt to the IMF and ECB, which as I noted last week, contributes to the question of whether the 50% figure will actually hold up (particularly given that Greek debt at every maturity is already trading at a 38 handle or less, and the 1-year yield is now up to a record 220%).
If the problem broadens to Italy (and mathematically, we suspect it will because Italy's debt now also violates the no-Ponzi condition), the implications are very unpleasant. Given leverage ratios of more than 40-to-1 for most European banks, there is no way to meaningfully restructure Italian debt without wiping out the capital base of Europe's banks, and forcing the nationalization of the entire European banking system.
To continue reading the article, click here.
Also check out:
