As U.S. politicians scramble to defend themselves against raising the federal government’s astronomical debt to an even higher level, Americans may be seeing the reflection of their own future in the grim picture of insolvency across Europe.
The so-called PIGS nations of the European Union (Portugal, Ireland, Greece, and Spain) are all caught in a vise: on one side, spiraling debt and obligations which can be serviced only through borrowing, and on the other, the increasing costs of borrowing resulting from profound doubt in the minds of potential buyers of government debt instruments that bonds can be repaid.
The PIGS have now become the PIIGS with the addition new member Italy, as on August 3 the yields of 10-year Italian government bonds hit a new high. (There is an inverse relationship between a bond's price and its yield.) The government sold €3.9 billion of bonds at a yield of 5.77 percent, significantly higher than the 4.94-percent yield in bonds sold as recently as June 28. The Bank of Italy's Deputy Director-General Ignazio Visco told the Italian parliament that each rise of 100 basis points in the cost of borrowing would be equal to a reduction in Italy's GDP by .2 percent in the first year and .4 percent and .5 percent in the second and third years.
According to Spiegel online,
The symptoms are all too familiar. The risk premium on Italian government bonds reached a new high on Monday, stocks fell and the Milan stock exchange restricted short-selling as a precaution.
Italy has suddenly become the focus of international investors' attention. New doubts about the stability of the Rome government and a deep skepticism about the country's finances have combined to form a dangerous mixture. The national debt is at 120 percent of gross domestic product (GDP), the second highest in the euro zone after Greece.
Italy now at center of Europe's debt crisis
Italy has found itself at the center of spiralling economic concerns in recent days. Fears that it might default on its huge debt have pushed up the cost of government borrowing and led Prime Minister Silvio Berlusconi to address lawmakers in a bid to reassure the markets.
Stock markets in the United States, Europe and Asia plunged Thursday and Friday amid fears about a global slowdown and anxiety that the kind of troubles seen elsewhere in Europe might drag Italy down, too.
A warning by European Commission President Jose Manuel Barroso that the euro area crisis was spreading beyond a handful of smaller members did nothing to help.
"We are no longer managing a crisis just in the euro area periphery," he said, as he urged European leaders to act quickly to carry out reforms. "Euro area financial stability must be safeguarded."
So what is behind the current crisis around the euro zone's third-largest economy? And what could it mean for Europe and the world if it escalates?
Domenico Lombardi, a senior fellow at the Brookings Institution and former International Monetary Fund executive board member, says the roots of Italy's troubles lie in its huge public debt and low growth rate.
Italy's economy has been growing at only 0.3%, he said, and most importantly is projected to grow at a similarly feeble rate for the next few years.
"This very low rate of growth really is one of the lowest in the world," he said, "and on top of that Italy has a very high public debt."
That debt stands at about 120% of gross domestic product (GDP) -- or in other words, a fifth more than the country's annual economic output -- and is one of the highest in the world, bar that of Greece, which has had to be bailed out by Europe.
Know about the European debt crisis in one post
Due to its huge debt load and slow growth, fears that Italy would develop a debt crisis have circulated for months, but they grew more pronounced after S&P downgraded its outlook on Italian debt in May. In June, Moody’s also threatened a downgrade, citing rising borrowing costs and the possibility that Italian Prime Minister Silvio Berlusconi, who is currently on trial for paying an underage girl for sex, might be forced out out. The next month, Berlusconi pushed through an austerity package intended to stave off a crisis as investors started selling off bonds. In recent days, interest rates have shot up amid fears that a Greek default would cause a domino effect, causing Spain and Italy to fall as well. The EFSF probably has enough funds to support Spain for a short time, but Italy, the euro zone’s third largest economy, would be incredibly expensive and perhaps impossible to bail out.
What it means for the euro zone: Many experts argue that the E.U.’s model, which concentrated monetary policy in the European Central Bank (ECB) while leaving fiscal policy to individual member states, is inherently unsustainable, as it denies member states monetary policy levers with which to help their recoveries. This also makes deficit-funded fiscal stimulus harder, as monetary policy can be used to keep borrowing costs low. When different countries are hit differently by a recession, as has happened now, the common monetary authority will act in ways that help some countries but not others. The ECB has pursued tight monetary policy that may prevent inflation in high-growth states like Germany but could also be worsening the recession in Greece, Spain, and other struggling states.
Most view one of two options going forward as likely. One is that the euro zone will lose members like Greece, Spain and Italy, either by them just leaving or by a default by any one of them, which could unravel the whole monetary union. Barry Eichengreen, a Berkeley economist, has said this would lead to a huge bank run and the “mother of all financial crises.” Another option is closer European fiscal union, so that fiscal policy can be coordinated at the continent level as well as monetary policy, bringing the E.U. closer to being a sovereign state.
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