Saving Italy and the EURO

If Europe and the U.S. can’t focus more on the long run conditions needed for healthy economies, they will never climb out of the short run emergencies they keep creating. Germany deserves credit for trying to do just that.

The fear is that panicky market investors may over price the risk of Italy defaulting on its debt raising interest costs on that debt to levels that Italy cannot afford, thus becoming a self-fulfilling prophecy. A sufficiently large European Financial Stability Facility (EFSF) that was prepared to lend to Italy (buy its bonds in the market) at more “reasonable” interest rates could give the Italian economy time to recover and grow out of its current problems. The mere existence of such an arrangement and commitment should reassure market investors making it unnecessary for the EFSF to actually buy any Italy debt, or so the thinking goes.

The fact of the matter is that substituting EU/IMF funding for market funding cannot reassure markets nor improve Italy’s long run prospects unless Italy itself takes the measures needed to reduce its government’s deficits and to improve the productivity and competitiveness of its economy. If Italy’s new government is successful in adopting and implementing truly credible measures to achieve these two goals, the market will continue lending with more modest risk premiums and no lending by the IMF or EFSF will be needed. To be sure, it will take time for such measures to take hold and actually improve Italy’s economic growth and improved competitiveness so it will need to continue borrowing from someone for a few more years. And by the way, balanced trade (imports paid for with exports so that no external borrowing is needed) does not require that Southern Europeans acquire Northern European work ethics. It only requires that they live within their means, whether they wish to work a lot or a little.

The European Central Bank (ECB) cannot save Italy by buying its sovereign debt. Those who point to the ECB as the savior of Italy, do so because the ECB can (by twisting or violating its mandate and charter) buy Italian bonds in unlimited amounts now, while the EFSF does not have sufficient funds for that and cannot acquire them soon enough. But once again, none of this will help in the long run unless Italy adopts corrective, market liberalizing measures that improve its economic performance (growth rate and external competitiveness). But leaning on the ECB has a very large risk rarely mentioned (though it is implicit in German reluctance to turn the ECB loose). The moment European markets (North and South) come to believe that the ECB will allow inflation to increase as a by produce of buying Italian bonds or for any other reason, interest rates will rise to reflect the higher expected inflation. Rates will rise not only in Italy, but also in Germany and everywhere else in the Euro zone. This really would be a disaster for the Euro.

Thus there is no substitute, no short cut, to Italy’s taking appropriate measures. Everyone is now so scared that I am optimistic that Italy will actual succeed in doing so. The IMF review of its measures requested by Italy should go a long way toward reducing market uncertainty about any measures taken. Dealing with the short-run in a proper way will make for a brighter future for everyone.