No real solution for Italy

SUBHEAD: On the brink. The risk in this situation is exponentially worse than failure of Lehman Brothers.  

By Bonnie Kavoussi on 11 November 2011 for Huffington Post -  

Image above: Police officers fire tear gas in Rome 10/15/11 as protesters in Rome smashed shop windows and torched cars. From (
Two weeks after European leaders trumpeted an agreement to expand a bailout fund they said would finally become large enough to prevent major countries from sliding into default, investors around the world remain deeply skeptical. That skepticism now looms as a growing source of danger for the global economy. As investors prove reluctant to lend to deeply indebted governments in Italy and Spain, that lack of confidence is increasing their borrowing costs and adding to the nations' debt burdens.
As interest rates on long-term Italian government debt this week spiked to a euro-era high of more than 7 percent, the markets seemed to be signaling more trouble ahead, with the very perception of trouble threatening to become a self-fulfilling prophecy: As confidence erodes in the ability of European governments to repay their mounting debts, lenders demand higher rates of return for their money, sending debt levels higher still -- a feedback loop of strife.

Some economists are now so pessimistic about the prospect that Europe can summon the finance -- not to mention the political will -- to arrest its deepening crisis that they are openly discussing the prospect of an Italian default, an event that would spread financial losses worldwide and perhaps trigger a global recession. It might spell the demise of the euro, the continent's shared currency, unleashing a fraught and messy process of dissolving the monetary union at its root.

"If there's a disorderly default by Italy, then you are really looking at the breakup of the eurozone," said Bernard Baumohl, chief global economist at the Economic Outlook Group. He added that if the European Central Bank proves unable to muster further support -- something that has so far been deemed unlikely -- that "would trigger a significant depression in Europe," with economies around the globe sagging as a result.
At the center of the latest concerns are enduring questions about the size of the European Financial Stability Facility, the bailout fund designed to reassure global investors that sufficient money has been set aside to eliminate worry that a major country could default. Ever since it was created last year, investors have focused on the size of the fund -- about $600 billion -- and the disagreements emanating from European capitals over their willingness to offer guarantees needed to make it big enough to rescue even a sizable nation such as Italy.

The deal in Brussels struck late last month was portrayed by participants as the crucial breakthrough that would finally dismiss such worries. Under the deal, the fund was to grow to more than $1.36 trillion by raising money from countries around the world and by providing risk insurance that would entice private investors to buy additional sovereign debt from troubled European countries.

But countries such as China, Japan and the United States have proven reluctant to invest in the bailout fund, concerned about the sanctity of their investments. European bickering combined with austerity measures seemed to underscore the reality of lean growth prospects that would make it harder for governments to repay their debts. As interest rates rise for troubled European countries, investors have become even more skittish about investing in European debt absent additional insurance.
The fund intends to expand in part by borrowing against its outstanding balance, a plan now limited as borrowing costs rise. All of this uncertainty about the fund's ability to expand has itself limited that ability by making investors increasingly nervous about participating.

"Investors generally are not altruistic," Baumohl said. "There is still a tremendous lack of clarity on how precisely these funds are going to be raised, what guarantees come with them."

The bailout fund requires at least two trillion dollars to pose an adequate barrier against the chance of an Italian default, Nariman Behravesh, chief economist at IHS Global Insight, told The Huffington Post.

For the fund to provide assurances that it could simultaneously rescue Italy, Spain, Greece, Ireland and Portugal, it requires as much as $6.8 trillion, estimated Nicholas Economides, an economist at New York University's Stern School of Business.

Without a credible path toward an expanded bailout fund, Europe is effectively back where it started before the Brussels summit late last month, say experts, only now the borrowing costs for troubled European countries are even higher.

As Europe's options for rescue narrow, experts are increasingly focused on the European Central Bank. The bank has historically refused to print euros en masse to address crisis, citing age-old fears of inflation -- a concern that resonates in Germany, where the government has led the charge to prevent the central bank from doing more.

But as circumstances grow more dire, Behravesh predicted the central bank would ultimately be forced to set aside its traditional mode and intervene, buying sovereign debt from troubled governments to drive interest rates down and put an end to the crisis.

If the central bank does not come to the rescue, European governments could still find their way out of the crisis by concentrating on generating economic growth that would enable them to pay down their debts in the long run, said Wells Fargo global economist Jay Bryson. In that scenario, Italy would need to follow through on promised structural reforms, such as making it easier to replace workers, which would in turn make investors more confident the country it can grow its way out of its debt crisis. Then interest rates on sovereign debt would fall, Bryson said.

Italy's Senate on Thursday passed some debt reduction measures that had been demanded by European leaders, which will raise the retirement age and privatize some services. The passing of the legislation has paved the way for Prime Minister Silvio Berlusconi to step down. He promised earlier in the week that he would resign once the austerity measures were approved.

In the estimation of many analysts, the survival of the euro and the immediate fortunes of the broader economy now hinge on whether Italy is able to transcend its political and financial turmoil, and find its way back to stability. If Italy defaults on its debt but does not abandon the euro, the currency could survive though the continent would be in for a recession, said Behravesh. But the central bank would almost certainly be required to rescue European banks holding Italian debt or face the failure of some major banks, especially lenders in France and Germany, he added.

But if Italy were to default, it might well feel pressure to abandon the euro in order to devalue its own currency, to make its debt burden smaller and its exports cheaper on global market. That would spell the end of the common currency, Behravesh said, a once unthinkable possibility that has suddenly become thinkable.

In that scenario, most other member countries would feel compelled to leave the euro as investors fled the continent, sending interest rates spiking to unbearable levels, and triggering large-scale bank failures. Investments in housing, stock markets, financial institutions and government bonds would all lose substantial value, he said, while consumer spending would collapse.

"The ECB can do it," Behravesh said, referring to the central bank as potential salvation. "If not, then I think this experiment's over."

By Bonnie Kavoussi on 9 November 2011 for Huffington Post - 
Italy default fears grow as borrowing costs rise over 7%. Market confidence in Italy's ability to pay its bills faded quickly on Wednesday, and experts warn that fears of Italian default could weigh heavily on the U.S. economy as it fights against a renewed economic downturn.

Interest rates on 10-year Italian bonds rose above 7 percent on Wednesday to a euro-era high, increasing by almost a full percentage point from Tuesday's rates. While the European Central Bank may yet step in to buy Italy's debt, allowing the nation to keep making payments on its current debt load, some economists say that it is becoming increasingly likely for Italy to default, dragging Europe and the United States into recession anew.

Italian Prime Minister Silvio Berlusconi, who has failed to fulfill his promises to European leaders to slash his government's massive debt, vowed Tuesday to step down once the Italian parliament has passed austerity measures. But that did not stop investors from demanding higher interest rates from Italy on Wednesday as fears mounted that an Italian default could freeze lending and send banks falling like dominoes.

"This is exponentially more serious than Lehman Brothers," said Bernard Baumohl, chief global economist at the Economic Outlook Group. "The exposure of the global banking system is much greater, and there is really a lack of any solution to this."

Nariman Behravesh, chief economist at the economic forecasting firm IHS Global Insight, estimated a 15- to 20-percent chance that Italy will default on its debt, which he said would cause bank runs, a credit crunch and a year-plus-long recession in Europe, leading to a recession in the United States that would send unemployment over 10 percent, he said.

Investors around the world panicked in response to the spike in Italian interest rates. The S&P 500 plummeted 3.67 percent, the DAX in Germany fell 2.21 percent and the value of the euro plunged 2 percent against the dollar. Bank stocks also took a beating, as shares for Goldman Sachs fell 8.21 percent, JPMorgan Chase stocks fell 7.08 percent and Morgan Stanley shares plunged 9.01 percent.

Economists say borrowing costs are a leading factor in Italy's possible default. Beyond the nation's staggering debt and its own economic contraction, Behravesh attributed the spike in those costs to political dysfunction in Europe. Italy will become much more likely to default, he said, if the interest rate on its debt rises above 8 percent.
The wider European bank failure likely sparked by an Italian default would likely cause other troubled countries in the euro zone -- such as Spain, Portugal and Greece -- to miss their debt payments, some economists say, as the other nations' higher borrowing costs make their debt burdens likewise unsustainable. Before long, the whole of Europe could be plunged into recession.
And that plunge would make wider waves. At 27 percent of the global economy, the European Union is the world's largest player, according to IHS Global Insight, and economists fear a deep recession in Europe would drag the rest of the world down, too.

Baumohl said that if Italy defaults on its debt, the United States would fall back into recession because exports to Europe would slow, banks would be forced to take losses on their European loans and debt insurance, and U.S. banks would tighten lending.

Behravesh said he expects the European Central Bank to come to the rescue. The ECB most likely will print more money to buy Italian bonds, he said, to allow Italy to keep financing its debt, and European leaders will probably boost the size of the European Financial Stability Facility, the euro bailout fund, to an amount that can at least calm markets.

"The ECB now is the only thing standing between Europe and the precipice, so in the end the Germans will come around," Behravesh said.

Borrowing costs for Italy would fall if the country implements the necessary budget cuts and structural reforms to allow its economy to grow and make its debt burden more sustainable, said Sung Won Sohn, an economist at California State University.

But Italy seems increasingly unable to address the crisis on its own. Since the country's liberal opposition party is "very beholden to unions" and the nation is entering a recession, it would be difficult for the government to implement the structural economic reforms and budget cuts necessary to reassure investors and lower interest rates, Behravesh said. Moreover, as the Italian economy shrinks, budget cuts are likely to worsen the economy and debt burden as taxpayers' incomes fall, he said.

An Italian default would endanger French banks the most, since they have invested $106.8 billion in Italian sovereign debt, according to the Bank for International Settlements. U.S. banks have invested $12.9 billion in Italian sovereign debt, which they would lose if Italy defaults.

Some economists say that it is also unlikely for Italy to abandon the euro, since the value of the Italian lira would plummet in the international markets. The rush to move Italian money elsewhere would crater the nation's banks people, rendering the move counterproductive, said New York University economist Nicholas Economides.

Stronger European economies might leave the euro if Italy defaults, however, a scenario that some economists see as more threatening. If banks holding European sovereign debt fail absent needed capital, the broader European economy would shrink sharply, endangering the stability of the euro zone as a whole, the economists warn.

Behravesh said he expects European leaders to strive to avoid a scenario in which Italy leaves the euro, which would likely precipitate a series of similar departures. After borrowing costs spike for other countries, he said, the temptation for them to devalue their own currencies to have cheaper exports and a cheaper sovereign debt burden would be irresistible.

"If Italy leaves, it's all over for the European experiment, as far as I'm concerned," Behravesh said.
Reuters reported on Wednesday that German and French leaders have discussed creating a smaller euro zone made up of stronger economies.

Behravesh said that while he can't imagine that European leaders have seriously discussed removing Italy from the euro zone, such "really irresponsible" political discussions are contributing to higher interest rates for Italy.

"That's not even playing with fire," he said. "It's playing with dynamite."

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