So. Farewell then, Mr Berlusconi. You were once the joke of the eurozone. You provided much hilarity on BBC One sketch shows (see above) and panel shows (see here and here after 1:10). You survived allegations of bribery, fraud, mafia collusion and under-age sex. But even you could not survive the markets. Ciao.
Now we move from farce to tragedy. A bailout of Italy looks all but inevitable. This is worrying for two reasons: first, there is not enough cash for a bailout. Italy is the 4th largest economy in Europe; it is the 8th largest in the world. The total needed could be more than €0.6 trillion, terrifying when the current EFSF lending capacity is €0.44 trillion. Second, there is a good risk of sovereign default. It is unknown whether this will cause financial meltdown, but it could do.
It is curious, because Italian finances are not the worst in the world. Italy runs a low budget deficit; in fact, it is currently running a primary budget surplus (ie before interest payments).
What then has caused such recent terror? One answer: borrowing costs. Italian borrowing costs have reached 7.5% at the time of writing. Paying off Italian debt under such rates is unsustainable. What caused them to hit such highs? Panic. Self-perpetuating panic, I would argue. Once investors become convinced that default is likely, they demand higher and higher repayment rates. Seeing rates ever rising, seeing Italy splashed all over the front pages: this only increases the panic. So rates rise even further.
News reporters have not helped over the past week. 7%, they have said over and over again, is the rate at which Portugal, Ireland and Greece were bailed out. This is true. But is it worth repeating? Is it worth reporting, 6% is very near the figure when Greece was bailed out? Is it worth saying, at 5%, investors fear rates could rise into Greek-style territories? If we keep repeating this figure – 7%, 7%, 7% – I wonder whether or not we imbue it with some talismanic quality. For Italy is not Greece. It has different levels of debt, different inflation rates, growth levels, deficit levels; so the figure-of-no-return could well differ from 7%. Yet by convincing ourselves that it is 7%, we also convince the markets – the strange world where thinking it makes it so.
I suppose media panic is inevitable. Market panic is not. In fact, market panic could have been stopped long ago: by boldness. The European Central Bank (ECB) could have stepped forward and guaranteed to buy limitless Italian bonds. Buying bonds would act to reduce interest rates. Italian borrowing costs would fall. It would also have the side-effect of convincing markets default is unlikely. Investors would demand lower rates of return. This option looked possible in August, when the ECB vowed to “actively” buy Italian and Spanish debt. On Thursday, however, the new ECB head Mario Draghi called bond purchase plans “temporary” and “limited”.
Why the timidity? First, the ECB is not legally mandated to directly support governments. Second, dissenting voices – particularly German-sounding ones – would grow louder. These opponents fear a looser monetary policy would tempt Mediterranean governments not to sort out their budgets. There is also a deep-seated German fear of inflation, after the hyperinflation of the 1920s.
These concerns aren’t reasonable . There would still be pressure on Southern euro-zone members to sort out public finances. Legal mandates should be tossed into the wind at a time of near-financial collapse. When the prize is to lower Italian borrowing costs, so that Italy can pay back its debts and avoid a bailout, fears even of 5% “hyperinflation” are unfounded. A looser monetary policy would make exchange rates of struggling Europe more competitive. Even if printing money led to inflation, it would be welcome: inflation erodes away debt.
The reason for the inaction of the central bank can be spelled out in one word: Germany. Germany has all the power in Europe and it hates the idea of a looser monetary policy. Germany is an large exporting market bewitched by budgetary discipline. Printing money would make its exports less competitive, reward countries for profligacy and cause run-away inflation: everything Germany hates. Yet this could be the only way to avoid an Italian bailout.
I leave the last word to heroic Tory grandee, Sir Peter Tapsell:
Chancellor Merkel knows very well that it was not inflation but high unemployment which, in my lifetime, brought down the Weimar republic, and [it] will do the same for the European Union.