Financial markets succumbed to a fresh bout of pessimism overnight, as investors queried the ability of the new Italian and Greek leaders to tackle the massive economic challenges they confront.
In Italy, Mario Monti is battling with shifting political alliances as he tries to assemble a parliamentary majority that can push through a program of budgetary austerity. Italians, used to the relaxed style of Silvio Berlusconi, now face the very real prospect of higher taxes and painful labour market reforms. On Twitter, Monti has acquired the epithet of “Rimontiamo” (go back).
Worries about Monti’s ability to implement these tough reforms were evident in the Italian bond market overnight. Italy sold €3 billion ($US4.1 billion) of five-year bonds, but had to pay a euro-era high yield of 6.29%. Meanwhile, the yield on 10-year Italian bonds climbed to the dangerous level of 6.63%.
In Greece, Lucas Papademos said that it was important to reassure its foreign creditors that Greece was fully committed to implementing its latest austerity program in exchange for receiving its latest €130 billion bailout.
Brussels has demanded that the heads of Greece’s political parties sign a written guarantee that they will support the austerity measures before Greece receives its next €8 billion payment of aid money. But Antonis Samaras, who heads the conservative New Democracy party, is refusing, saying that his word is enough, and that he won’t sign anything under external pressure.
As John Hussman, of Hussman Funds, points out, Italy, with its staggering €1.9 trillion of debt, now finds itself in very much the situation that Greece was in 18 months ago, when it was hoped that painful cuts in government spending would shrink the budget deficit. “They didn’t,” he says. “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.”
Hussman argues that Europe’s problems are beyond the point where greater austerity will be enough, particularly as there is a growing likelihood of a global recession. And European banks simply don’t have enough capital to cope with a major restructuring of Italy’s debt. “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 nationalisation of the entire European banking system.”
Hussman argues that the eurozone’s biggest problem is that debt-laden countries no longer have the ability to print their own currency, which allows them to achieve a soft default on their debts, because they repay their loans in a weaker currency. And the euro itself can’t be sharply devalued while Germany insists that European Central Bank should not be allowed to print money and buy vast quantities of bonds issued by debt-strapped countries.
As Hussman notes, there are only three solutions. First, eurozone countries could all surrender their right to decide their own budget policies without getting the approval from a central eurozone agency. (This would be the condition on which Germany would allow the ECB to start buying more bonds.) But countries will be very unlikely to hand over budgetary powers, particularly with the threat of a looming recession.
Secondly, Hussman suggests that debt-laden countries could start a dual-currency system, issuing new bonds that have the option of being converted into currencies such as drachmas or liras. Investors would probably demand that these new bonds pay a higher interest rate, to compensate for the risk that the loans could be converted into a weaker currency. But, as Hussman notes, they’re already charging higher interest rates to compensate for the risk of default. As Hussman sees it, “this is probably the best option for Europe, but is not one that distressed countries will choose on their own so long as bailouts can be extracted”.
The alternative is for Germany to adopt a dual currency system itself. According to Hussman, it would take about a week for Germany to convert all of its euro-denominated debt into debt denominated in deutschemarks. It could introduce the deutschemark as legal tender just as quickly. With Germany out of the euro, the ECB could then print as much money as it wanted, and save the debt-strapped eurozone countries from default. However, he notes that this approach would create difficulties for German companies that have long-term contracts where they are paid in euros, and it would also sharply narrow Germany’s trade surplus with the rest of Europe.
But, he notes, “ultimately, all of the possible outcomes are undesirable solutions, but we are now in a world where good solutions are no longer on the menu.
“The bottom line is that you can’t have a common monetary union without common fiscal restraint, and Europe is much too far along to achieve a necessary fiscal convergence without some sort of debt restructuring or devaluation among its weaker members.”
*This article was originally published at Business Spectator