Promises, Promises, But More Than A Technical Detail

Well the eurozone government deficit problem has hit the agenda with a thud again in the last few days. Yesterday the FT ran a story about how the ECB has decided that it will not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. (Dave Altig at MacroBlog has also covered the story here, and Nouriel Roubini here). Today the FT has another story about how Trichet has confirmed the policy, and how the Commission too plans to get tough (well they would, wouldn’t they, since this may now become a credibility auction).

This topic must appear appaulingly technical and yawn-provoking to the non-economist. In fact nothing could be further from the truth. Let me explain a bit.

Basically the situation we have had to date has been that the ECB has accepted the bonds of any one country as equivalent to the bonds of any other, just like a one euro coin from France is treated as equivalent to a one euro coin from Finland in any shop in the Eurozone. The ECB makes its presence felt on this via the assets it accepts as reserve deposits from eurozone central banks.

Now basically this decision is a vote of only limited confidence in the mechanisms put in place by the EU commission via the Stability and Growth Pact. Italy has been given two years grace to put its house in order. Serious doubts remain as to whether anything will really change significantly during the next two years, but if it doesn’t the fiscal credibility of the Commission will be in tatters. The ECB is cleary concerned that its credibility may also go west in the process (a clear case if there was one of ‘credibility rot’). So the bank has put up a marker: here and no further. This is always a difficult thing to do, since if you ever say never, and then change your mind, you obviously end up with egg all over your face (the ‘moral hazard’ issue is all about this).

This decision is an important one (I would even say a landmark one) since it is hard to see how there can be a turning back. Basically the ECB is saying to the Italian government: you may be able to pull the wool over their eyes up in Brussels, now try the same ploy with the rating agencies.

Well, if the Italian government desists from excess deficits there will be no issue, but my fear is that they may not be able to.

Basically, and plagiarising Brad Setser and Nouriel Roubini just a little: ‘demographics also matter’. The problem isn’t simply that Italy has had a series of governments that have been systematically profligate. It also has possibly the most rapidly ageing population on the planet (it is about to overtake Japan, and then in turn be overtaken by Spain as the oldest country if the UN projections are valid). So this is about sustainable fiscal dynamics and tax wedges vis-a-vis employment generation. The Italian government really is between the proverbial rock and the hard place.

In reality I imagine that what we will see is a steady drift away from central bank willingness to hold Italian paper in reserves (it is important to bear in mind here that the ECB itself has relatively little capitalisation, and each country still has its own central bank, and its own reserves). So the other central banks (and who knows, Asian central banks and anyone else who holds sizeable quantities of eurozone paper) may well slowly move Italian paper out of their reserves. After all, if the ultimate guarantor isn’t willing to accept at par, who else is going to risk it.

The consequence of this is that the so-called yield spread – the difference in effective interest rate operating on a 10 year German bund and that on a similar bond from the country in question – should start to widen (at presnt Italian bonds are trading with a differential of a little over 20 base points, or 0.2%, over the German bund). This is very likely now to widen: probably slowly but steadily.

Morgan Stanley economist Joaquim Fels (who I do think is at least listened to over at the ECB these days) has been arguing for some time now that the fact that the ECB treated all euro-govt-bonds at par was one of the principal anchors preventing a thickening in the yield spread. Well now the anchor has been cut (rather than weighed). What can now happen is that each time the Italian deficit fails to comply with promises and forecasts, someone, somewhere can try and test the spread. In the beginning I imagine this will be a non event, but just give it time. A little crack has open up in the wall, and now some will know no rest until it has finally been breached. The ECB decision has opened up the real possibility of speculative attacks against sovereign debt inside the eurozone, and this is obviously a first, in fact *the* first new possibility on the horizon since the euro was launched.

As I say, I think a decision like this is very hard to go back on, so it is difficult to see how the ECB could ‘blink’ here even if it wanted to. A ‘bail out’ could be arranged indirectly if the yield spread grew too much, but to keep doing this you need to be convinced that Italian growth and fiscal policy will get back onto a sustainable trajectory. I am not convinced that they will, and thus there may well be a ‘high-noon’ situation.

Of course, we are only at the begining of a long process here, butas I say I think this decision is a landmark one.

Also, again plagiarising Nouriel Roubini and the late lamented Rudi Dornbusch: politics matter. The backdrop to all this is the recent failure of the EU constitution vote, long standing frustration at Eurostat about blatantly falsified Italian data, and now the Fazio affair, where EU internal market commissioner Charlie McCreevy seems to be so frustrated that he is actually demanding that legal action be taken against the governor of the central bank in a sovereign state. I guess this would also be another euro first.

Many worry these days about the level of tolerance for globalisation and the dangers of protectionism, but my guess is that the danger of a kind of ‘internal protectionism’ inside the EU, with citizens in one country being reluctant to bail out citizens in another, is a much more real and present danger. Note how Dutch finance minister Gerrit Zalm has taken a ringside seat to applaud the ECB initiative.

Bottom line: we’ve just pushed the boat out and there may now be no easy way to draw it back in again.

Anybody wanting a more serious academic background explanation to all this could do worse than this paper by Buiter and Sibert: How the Eurosystem’s Open Market Operations Weaken Fiscal Discipline in the Eurozone (and what to do about it) (Hat Tip to Nouriel Roubini).

17 thoughts on “Promises, Promises, But More Than A Technical Detail

  1. Strangely Hans the topic hasn’t surfaced in Spain either. Obviously any big issue with Italian debt would have a knock-on effect on Spain, where the problem is not sovereign debt, but huge private indebtedness, fuelled by those incredibly low interest rates (for Spain) via a banking system which is also indirectly guaranteed by the same (ECB warrantor of last resort) mechanism.

  2. “2nd question is, will the usual suspects like Italy take note?”

    The point is CapTVK I don’t think they can. I think we’re past that stage. Demographics among other things have driven Italian trend growth into the 0-1% range. Seriously running budget surpluses to reduce the accumulated deficit would obviously mean ongoing *negative* growth. I think that is politically impossible in Italy (this kind of sacrifice may be more doable in Portugal, I have no idea about Greece).

    So I imagine other ‘more creative’ strategies are now under active consideration somewhere.

  3. Add in the rumors of Italy redenominating its debt in reissued liras, and the Euro is going to have a problem. Other countries with weak balance sheets will see the yield spread appear in their own bonds. Maintaining a continent-wide interest rate is going to be a lot more difficult if the market has already decided to price different flavors of Euro debt differently.

    Rumor source:,,8210-1726064,00.html

  4. Mitch,

    I don’t think that August article by Kaletsky adds any new info. The possibility of Italian withdrawal and subsequent sovereign default has been widely discussed (including on this site by me). Clearly in this event the Italian govt (like the Argentinian one before it) would convert the debt.

    I don’t think the issue is simply one of euro value and monetary conditions. Monetary conditions in the euro zone are pretty loose (that’s how Italy got into all this debt) and the euro has, of course, fallen from its earlier substantial highs. No, I fear that the level of debt itself may now provoke its own lethal spiral, particularly in the context of Italy’s rapidly ageing workforce and population. Plus really it is difficult to see the gravy train driven Italian political system adapting itself to making repeated calls for civic belt-tightening.

    I think there is neither the will nor the way.

    Curiously the ECB in suggesting it will remove itself as guarantor of liquidity of Italian debt if x happens may in fact cause x to happen, since the financial markets may decide that this in itself changes Italy’s credit rating: ie the situation may now be circular.

    And btw, any chaos in euro-bond markets and the european banking system would rapidly make itself felt on the other side of the Atlantic too, so it won’t only be Europe that has the problem. Remember debt to the tune of 105% of the Italian GDP isn’t small beer.

    Capital flight to the US dollar would only send the dollar up and up, and the resulting situation would IMHO be also insustainable.

  5. Edward, what kind of time frame are we talking about in all of this overtaking? Imminent, as in 1-3 years, or medium-term, as in 4-10 years?

    Belgium went into the euro with accumulated debt well above the Maastricht criteria (in 97/98 it was about 110 percent of GDP iirc), but I’m thinking it has been paid down considerably. Are their demographics and growth so different from Italy’s? Or is it another case of managing a smaller economy being different from managing a G7 economy?

    Sorry for all the questions, but I think they might help to tease out some likely trajectories.

    My short, sweet and slightly snarky initial take was that the bond traders had to have something to do. They put on the euro-convergence play in the first place, and with convergence in Central Europe a) a little behind schedule and b) smallish bond markets anyway, unwinding euro-zone convergence isn’t such an unlikely approach. Gotta do something with all that liquidity.

  6. You are right about the debt levels themselves being a separate danger. I just don’t see how long a one-size-fits-all monetary policy can be sustained under the circumstances. The risk factors will push rates apart, especially given your point about the ECB threatening to withdraw its guarantee.

    No one here is gloating. This could get ugly.

  7. “Monetary conditions in the euro zone are pretty loose (that’s how Italy got into all this debt)”
    I would argue that Italy got into most of this debt before there even was an euro zone.

  8. “what kind of time frame are we talking about in all of this overtaking? Imminent, as in 1-3 years, or medium-term, as in 4-10 years?”

    This is very hard to say, I’m just guessing, but my best gues is somewhere on the threshold between what you call imminent and medium term. ie 3 to 5 years, but that is only a guess. This all depends on too many other things: eg what happens to interest rates generally. Basically Italy can’t afford a sudden and sharp rise in interest rates.

    “Belgium went into the euro with accumulated debt well above the Maastricht criteria (in 97/98 it was about 110 percent of GDP iirc), but I’m thinking it has been paid down considerably”

    This is true. Belgium entered the ‘good dynamic, and now the deficit is coming down. Belgium does aamof a slightly higher TFR than Italy (1.6 vs 1.3) but I’m not trying to make fertility rates a causal determinant here, they are just a conditioning factor.

    I would say the big difference between Belgium and Italy lies in the *will to change* of the political class, and in the use of things like outright deceit in the construction of financial and economic data.

    Belgium (about which I actually know embarassingly little) seems to have been more serious in implementing reform, and still has a rather more generally boyant economy than Italy does. Look eg at productivity, which in Italy has been negative in the last few years.

    Italy could escape the trap, of course, but to date we have little evidence to suggest that those with power and influence are even seriously going to try.

  9. Mitch,

    “I just don’t see how long a one-size-fits-all monetary policy can be sustained under the circumstances”

    I agree. I have never been an admirer of the one size fits all philosophy. My feeling is that de facto it is now coming to an end. Country spreads should now begin to seriously widen (that after all is the intent) and this will influence longer term rates in each country. If one or more country looses the liquidity guarantee from the ECB at some stage – and as I say, the danger of this happening will now be internalised by the rating agencies in their assessments, ie the ‘credit-worthiness’ of the affected countries has already deteriorated – then the eurozone will become a hybrid entity, with an inner-core and an outer-group.

    I’m trying to figure out the impact here in Spain, where the government debt question is a non-issue, but private indebtedness has gone beyond all credible limits, rising 20% y-o-y last year alone. Here it is not the Spanish government, but the Spanish banks who are exposed to any significant change in interest rates, and in the end there should be an impact on the rates at which *they* can borrow money. I just can’t get my head round the mechanism yet. But surely the heady days of complete financial market integration at the eurobond level are steadily coming to an end.

    Curly Wurly

    “I would argue that Italy got into most of this debt before there even was an euro zone.”

    This is very possible, I haven’t been back through the numbers, although remember of course that during the second half of the ninetees, with the EMU process in the background, there was a steady converge in pre-euro interest rates.

  10. “In 1990 it already stood at 112% of GDP”

    Point taken Curly Wurly, but look what happened next: Italy was violently catapulted out of EMU. They were re-admited (mistakenly in my view since it now turns out much of the data was falsified) since they *seemed* to be addressing the issue. They weren’t, and now we are getting back to where we started, only the approaching liabilities of the ageing population are now much greater. Fifteen years has been effectively wasted. Consclusion………..

    Anyway thanks for the data links. (and the anti spam info).

  11. A commentor called ‘Russki’ put up a comment on my comments over at Dave Altigs macro blog, and I think his point is worth repeating:

    My point:

    “the ECB has been effectively guaranteeing Italy’s credit worthiness”…

    Russki’s point:

    “well, this is the multi-million euro question. The ECB is explicitly NOT the ‘lender of last resort’ for the Euro-zone countries. Legally it cannot bail them out in case of a default or threat of defaul, which amounts to the same thing. Yet the markets have discounted that piece of legislation as non-credible. How can a technocratic institution like the ECB not bend to the will of the political masters. If that is indeed the logic of the markets, then ECB’s refusal to accept Greek or Italian bonds as collateral may not be credible. Carrying this ad absurdum, even if Italy cannot swap its sovereign bonds for liquidity the markets will not speculate against Italy because they believe ultimately the ECB will step in.”

    My reply:

    “I fully accept the force of this point russki. The Italian government may also believe it, which may mean they don’t take the warning too seriously either, and carry on regardless. In which case a “push comes to shove” situation may arise (in fact I personally am convinced it will). Since on the view you provide, no-one will have been discounting anything, then in the crunch moment the adjustment can indeed be sudden and dramatic. What’s it called, oh yes, a *hard* landing.”

Comments are closed.