By Michael Hendrix, Research Manager
Take your mind back to 2008, when the go-go days of the 90s weren’t such a distant memory and there were only echoes of a growing storm on Wall Street. Rumor had it that banks had stuffed their balance sheets with bad loans of unknown value. Main Street seemed fine, but the storm clouds were growing and casting a deepening shadow. It wasn’t until September of that year that Lehman Brothers shook our complacency. A known entity was being threatened and in time we saw the venerable bank collapse. Yet we still thought ourselves sheltered from the storm. Time and loss proved us wrong. We weren’t as safe as we thought we were.
Now, what if you had been told at the time of Lehman’s collapse that its liabilities were much larger than people claimed; not just two times, but three times its stated size? What if $2.6 trillion in debt was hanging in the balance? Would you have been more concerned about the health of the economy then, about contagion, with the apparent maladies of Wall Street infecting Main Street?
Brink of Disaster
I know that I would be concerned, almost dearly so. So, what if I told you that the hypothetical I posed was real? Today, Italy stands on the brink of disaster. It is the third largest debtor in the world, paired with some of the slowest growth in the world. Its leaders dither and prevaricate like there’s a tomorrow. And all the while countries on its periphery suffer from equally dire debt burdens – one readily thinks of Greece, Ireland, and Portugal, all countries whose combined debt don’t even come close to equaling that of Italy’s.
In short, the tempest that blew through the world economy in 2008, the one we’ve been recovering from for nearly three years now, may not even hold a candle to what may be on the horizon today. Just as in 2008, we are distracted by lesser worries, such as Christmas tree taxes and Kardashian drama.
What’s at Stake?
Let’s be real then about what’s at stake. First, the sanctity of Italy hangs in the balance. Why? Since the turn of the millennium, Italy’s growth has hovered around zero. Its economy is tangled in a mess of red tape in the eyes of the IMF. Productivity growth, as measured by the OECD, has barely crept past 1% in the past ten years. Unemployment among the young sits at 27%, such that Italy’s most productive workers are left working part-time or short-term jobs for their best years. To top it all off, Italy’s good governance indicators have been cratering since 2000 as well. This is a product not just of poor political leadership but of endemic levels corruption that chew up more than 17% of Italy’s GDP every year.
As of this week, a fatal threshold has been crossed. Similarly to Lehman Brothers, Italy stays afloat as long as its debt can be rolled over and then papered over with new debt issuance. When Italian debt hit the 7% interest mark on the open market on Wednesday, traders had to start posting further collateral every time they handled Italian bonds in order to protect against the risk of default. Ignoring the significant psychological impact that crossing that 7% line holds, Italy quite simply faces the haunting likelihood that when it turns to the bond market to issue further debt for obligations new and old, that traders will throw up their hands and say it’s not worth the cost. It happened with Lehman and we know how that story ended.
Without the European Central Bank (ECB) stepping in to guarantee Italy’s debts (which it would somehow have to make credible) or buy its bonds in large quantities on the open market (which it has so far refused to do), Italy will likely default on its debts. Any large-scale ECB action would likely be made on the assumption that Italy’s problem is one of liquidity rather than solvency, and it increasingly looks like the latter. The European Financial Stability Facility, first created in May of last year to stem the European sovereign debt crisis, would simply be overwhelmed in the event of an Italian claim. Banks across the Eurozone would be hit by a tidal wave of red ink, and on top of that American banks are more exposed to Italian debt than to any other Eurozone country.
Even with ECB support and a technocratic government at the helm in Italy, the only real way out of its debt burden is economic growth, and that takes time that the bond market may not provide. According to Barclays this week, “Italy may be beyond the point of no return.”
The Eurozone itself is at stake too. It’s no longer a matter of a two-speed Europe, with the fast (Germany) funding the slow (Greece). We are already there. As many Euro-crats are starting to murmur, we’re more likely at the point of a two-tiered Europe, with only the strongest countries holding on to the Euro. As one European Union (EU) official said this week, “‘The difference now is that some countries are moving forward very quickly … The risk of a split, of a two-speed Europe, has never been so real.’” The scariest prospect is simply that no one knows what happens then. European Community law makes no provision for a country to leave the Euro. It’s uncharted territory, and there’s nothing like the fear of the unknown to spur credit contraction.
Faced with dire prospects at all turns, Italy itself could very well choose to simply switch its currency back to the lira from the euro. The low interest rates of the Eurozone clearly no longer hold true, and having its own currency would allow Italy to inflate away its debts and makes its exports more cost competitive. On paper, it’s quite an easy prospect. Italian legislators could simply pass a law saying that all financial transactions were to be conducted in lira and Italy’s problems would be solved. Except that’s not quite the whole story. If you knew that by tomorrow all of your dollar savings would be worth half their value tomorrow, what would you do? If it were me, I would send my money out of the country to someplace where its value would stay intact. Imagine a whole country doing that — at the same time. It would be one of the largest bank runs in history; that is, until capital controls and travel restrictions ensued causing chaos of their own. At that point, you wouldn’t be incorrect to expect a domino effect (the fact that this statement vaguely rhymes doesn’t improvement its reality), with Greece and others choosing to re-adopt their own currencies. At that point, the Eurozone would become a shell of its former self.
Ryan Avent at The Economist summed it up well:
“I have been examining and re-examining the situation, trying to find the potential happy ending. It isn’t there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world’s eighth largest economy and third largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn’t clear, but it’s unlikely to be pretty.”
As the dust settled on Lehman Brothers’ collapse in 2008, talk turned to whether banks were “too big to fail.” With storm clouds growing now over Europe, the threat now may very well be whether a country is too big to save.