November 11, 2011

Roubini on Italy

Fun times for Europe ahead - from Nouriel Roubini:
Why Italy�s Days in the Eurozone May Be Numbered
With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt of �1,900bn. That would partially address its �stock� problem of large and unsustainable debt but it would not resolve its �flow� problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.

To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.

Until recently the argument was being made that Italy and Spain, unlike the clearly insolvent Greece, were illiquid but solvent given austerity and reforms. But once a country that is illiquid loses its market credibility, it takes time � usually a year or so � to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario skeptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable.

So Italy and other illiquid, but solvent, sovereigns need a �big bazooka� to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone.
Just a little ray of sunshine. And nobody is willing to pony up the Lira needed to bail them out -- bad return on investment:
Output now is in a vicious free fall. More austerity and reforms � that are necessary for medium-term sustainability � will make this recession worse. Raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable.
Posted by DaveH at November 11, 2011 4:08 PM
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