Italy’s Spiral Calls Germany’s Bluff

11/09/2011 11:51 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Berlin will either have to accept unlimited ECB purchases of Italian bonds, or else a banking crash and Eurozone collapse, writes senior editor Igor Greenwald.

As always after one of Silvio Berlusconi’s debauches, it will be up to someone else to clean up the mess.

The Italian duce finally sort-of abdicated Tuesday, pledging to resign just as soon as parliament approves the latest austerity plan.

And after that, said the long-serving prime minister, would come new elections. Holders of Italian bonds were now faced with months of political paralysis, just as the country is sliding into an unaffordable recession.

They sold, triggering higher margin requirements for Italian debt, and therefore even more selling. The ten-year yield topped out at 7.48%, before retreating to 7.25% more recently. That’s up from 4.7% in early June, and 5.5% just a month ago.

Italy is a slow-growing country with a national debt at 120% GDP, so the past month’s move has stolen the financial benefits of all the growth it can reasonably expect over the next few years.

Italian yields are now at the nosebleed levels that forced Greece, Ireland, and Portugal out of the debt markets and into the painful grasp of European rescuers insistent on austerity. Except that Italy is too big to be financed by its flinty allies in the same way.

And its private lenders are unlikely to relent anytime soon, because the spike in yields is a viciously circular self-fulfilling prophesy, undermining Italy’s $2.6 trillion debt pyramid. That much falling masonry could, in turn, flatten many of the shakier European banks, causing an economic disaster of global proportions.

The question now is whether the crisis will degenerate into a financial crash and disorderly default, or whether the European Central Bank will buy Italian bonds from all comers in unlimited amounts until yields fall to a sustainable level.

The latter option has been anathema to Germany and its northern allies, but it was always hoped they would make the leap to the practical side once the abyss loomed. That moment is just about here.

Central banks exist in large part to serve as a lender of last resort. German refusal to let the ECB fulfill that role is a recent and radical departure from longstanding principles of economic management.

Now we’ll see just how much Germany values its ideology. A series of big banking failures and a deep recession would be a costly monument to minimalism.

I’m guessing the Germans will ultimately come around to see the need for unlimited ECB bond purchases, in exchange for painful austerity by the issuers of such debt. But their conversion, if it comes at all, is likely to be gradual and unlikely to be advertised, as this would weaken Germany’s leverage for extracting its pound of flesh from the client states.

That leaves us with Italian yields as the all-important indicator of market health. And as long as that remains the case, we’re not in a healthy situation.

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