Debt crisis: ECB in the Italian trap
6 September 2011
Il Sole-24 Ore
Faced with the risk of Italian default, the European Central Bank opted to provide support for Italy’s sovereign bonds in exchange for a commitment from Rome that it would rapidly implement of a package of austerity measures. Now the Berlusconi government’s failure to take decisive action is seriously threatening the credibility of the ECB.
A month ago, the yield spread between Italian multi-year bonds and German bunds reached 413 basis points (that is to say 4.13%). Without immediate intervention from the European Central Bank (ECB), the Italian government was about to be locked out of financial markets, and effectively forced to default. It was for this reason that Trichet wrote to Berlusconi: and it is said that in his much talked about letter, the ECB pledged to buy up Italian bonds in exchange for a Italian government commitment to boost growth and to balance the nation’s books by 2013. The ECB’s intervention was based on the hypothesis that the markets – which were excessively pessimistic – had doubts about the Italian government’s capacity to repay its debts and restore economic growth. The goal of the letter of intention was to contribute to the credibility of an Italian government initiative. And it was assumed that in association with a number of strategic purchases on the secondary market, it would be enough to stabilise the situation. That said, the success of the ECB’s intervention was contingent on one condition: the Italian government had to rapidly adopt an adequate budgetary adjustment plan. In spite of the large sums involved, the purchase of Italian bonds by the ECB was only a symptomatic treatment. The European institution had the clout to scare speculators, but if the underlying situation did not change the benefits of its intervention would vanish almost immediately.
Faced with a dilemma
And this is precisely what happened. The ECB’s intervention in tandem with the presentation of ambitious austerity package by the Italian government reduced the yield spread to less than 300 points. However, this was temporary respite and not a definitive turning point. The markets still remained unconvinced about the effectiveness of the Italian austerity measures. Thereafter, internal conflicts in the Italian government resulted in number of negative consequences. The European Central Bank was hoping that it would simply have to dictate its conditions for an austerity package that the Italian government should have adopted in early July. However, this turned out to be wishful thinking. Reassured by the reduction in the yield spread, the Italian government began to slowly back away from some of the package’s key measures. Plans to cut funding for local governments and to introduce a “solidarity contribution” were put on hold, significantly reducing the scope and the impact of the overall initiative. As a result, the European Cental Bank is now faced with a dilemma. If it wants to promote the process of European integration, it will have to punish Italy, or at least punish its government for not delivering on its promise. The feasibility of fiscal union, with the all of the transfers that it entails, depends on the capacity of European institutions to control national governments that overspend. If they do not have enough control, transfers will only serve to prolong financial crises in member states, without resolving them. And with this in mind, it is clear that if the ECB continues to provide support for Italy, which has failed to keep its word, it will sacrifice all future credibility, and, in so doing, endanger the continued existence of the European Union.
However, the ECB is also well aware that if it abandons Italy to its fate, it will mean the end of the euro. In its attempt to push the Italian government to do its duty, the ECB has highlighted its lack of credibility, and pardoxically damaged its image. In spite of the ECB purchases, tomorrow the yield spread between Italian and German bonds could once gain begin to increase. Naturally, without support from the ECB, the situation could quickly become more serious than it was on 5 August. And even if the European Financial Stabilisation Mechansim (EFSM) decided to intervene, it would not have the necessary reources to do so. What’s more, even if there was sufficient political will for such an intervention, there would not be enough time for all of the votes in national parliaments that would be required to increase the capacity of the EFSM. If the ECB allows it to fall, Italy – and as a result the Italian banks which have major sovereign debt holdings – will almost inevitably be forced to default. The ensuing crisis would quickly spread to German and French banks with nightmarish consequences – and in such a scenario the euro probably not survive. In other words, a bid to punish the Italian government would be so disastrous, the European Central Bank cannot even threaten the country. And as a result, its credibility has been undermined. It assumed it would be easy to control the Italian government, but the paradox is that it has now itself become the victim of that assumption. So what will be the outcome of this dilemma? Our parliament will have to punish the Italian government for its ineptitude. This is not an issue of who has the majority, but rather one of the capacity and credibility that a government needs if it is to take the initiative. Either we will have to change, or we will have to leave Europe.