Greece, Italy and the Euro

Borg

The rates are going up because people who live and breathe market analysis see the Italian debt as unsustainable. There is a real probability that they will borrow more money than they can pay back. That increased risk is what is driving the rates.

Cautious investors don't want the risk and the investors that are willing to take the risk want a return that is commensurate with the risk that they are taking. Even the Chinese, who have huge amounts of cash, don't want anything to do with them right now. That could change but China would probably want additional guarantees.

Italy can possibly fix this but not if they continue with the status quo of their spending habits. The longer that continues, the more likely it is that they could have a default of some sort and someone will get stuck holding a bag of worthless Italian bonds.

mheslep

Clearly margin buying and rampant speculation were causes of the 1929 stock crash; the follow-on great depression was caused by the Federal Reserve acting to cut off the money supply, and, I think, was in part due to the actions of the federal government, especially raising tariffs on imports and other dramatic interference in the private economy, along with a deliberate PR campaign to vilify business.

Nikitin

I don't know much about the federal government's involvement, though I seriously doubt its involvement was destructive, but I'm pretty sure the stock market crash was not merely a symptom. Loads of people were loaning money from the banks and putting the money into the stock market. When the stock market crashed, lots of people were without money to repay the banks.

Yup. Though if you're buying 10-year bonds It'd be silly to worry about Berlusconi being booted and some financial problems. Chances are Italy will get into much bigger trouble than this during a 10 year period, thus the yield increase isn't really rational.

Nikitin

No, the CDS predicted that Greece would default on its loans {again}. The prediction was right, as Greek debt was haircut (not a technical default as that would be catastrophic, but a default none the less).

Borg

I didn't say anything about Berlusconi or that this has anything to do with him. You're not making sense w.r.t. the bonds. If Italy defaults, the 10 year bonds will be worth zero. That is clearly something for the markets to worry about.

Nikitin

This has everything to do with Berlusconi. The yield jumped from a sustainable rate to 7,4% directly due to the political squabbling and Berlusconi's removal.

Italy will not default due to some political instability. Italy will default if its debt gets out of control and economy start to break down.

My point was, that it is highly improbable that Italy won't get into worse trouble than it is in today. The yield of 10 year bonds shouldn't really be affected much by current events, but by the structural health of the Italian economy (which isn't nearly as bad as Greece's or Protgual's).

MarcoD

I agree, I stand corrected. The market predicted a haircut and it happened in the Greek case. I saw that the Italian CDSs became somewhat more expensive but I can't translate it to a probability on an Italian default. I think I heard it being translated to around 50% on the radio, but I might have gotten it wrong.

I am a bit baffled by people proposing that the ECB should buy the Italian debt though. I mean, that's equivalent to just printing money to buy debt, right? Looks to me that they can do that a little bit, but at the risk of (hyper-)inflation, pushing up the interest rates of all European economies, and subsequently blowing up the whole of Europe. I mean, Dutch interest rates are 2.2% now, what happens if all European governments need to borrow at 7%?

mheslep

Greece, Italy and the Euro Thread:

There had been several similar panics prior to 1929; in those instances the market and economy always recovered within a year or so. The 1907 panic caused a 50% stock drop which returned to previous highs within eight months. In the months after the 1929 panic the stock market recovered half its value before the government via the actions of the Federal Reserve turned the panic into a national banking collapse which began the Great Depression. There is debate about the impact of policy actions by the US government itself (i.e. not the central bank) with regards to extending or shortening the Depression, but there is no question that at least some of those actions were destructive; NIRA in particular was found unconstitutional and was cancelled.

http://en.wikipedia.org/wiki/Causes_...eat_Depression

John Creighto

If all of the European governments needed to borrow at 7% then certainly the Dutch interest rate wouldn’t be 2.2%. If the European central banks were trying to not change the money supply they could sell their Dutch debt and buy Italian debt. All central banks influences the money supply by their actions. The only question is how should they do it and how much should they do it.

klimatos

I have a daughter who is very high in international banking circles. She predicted every step of the Lehman Brothers fiasco months in advance and warned the Bank of England that they were about to be ripped off. The Bank's response was, "No, No, No. The US wouldn't do that to us!" Now, they know better.

By the way, she predicts that Bank of America will be in Chapter 11 within six months.

MarcoD

Yah, that was my point, that with too much inflation all the European governments would need to pay too much interest and in the end the European economy would blow up.

Somehow, given the lack of interest of the ECB and other affiliated central banks, I have the feeling that they are laughing their heads off.

(I checked the assets of the Dutch Central Bank, which is a member on the council of the ECB. I doubt the assets of all the European central banks combined are enough to fill the Italian debt hole, so the ECB can only buy debt with freshly 'printed' money, or European banks chip in. That's the silly thing: I doubt there even would be a debt problem if all the European banks agree to buy the debt. But that's similar like giving a blank cheque to government... seems like a lousy idea to me.)

DoggerDan

Precisely. No matter how bad things get, life moves on. Sometimes sooner, sometimes later.

Still, we persist.

John Creighto

I think the facts are something like this (I need to confirm this with sources). I think the interest rates quoted are for loans with two year terms. For Italy 7% is considered dangerous. 5% is considered stable. Markets valued Greek debt at 50% before the haircut. The actually haircut I think was effectively 20%. That's about a 10% loss per year. If both the risk free rate of return was 2% (which is the target inflation rate) and a 20% haircut was considered likely then one might expect a fair market value for the interest rate on Italian debt to be around 12%.


The fact that interest rates are only 7% could mean the markets think one of the following:
1)the risk of an Itialian debt haircut isn't significant
2)the governments will cover the risk of Italian debt
3)their will be about 5% deflation per year.

For point 1, the Italian economy is considered in much better shape then Greece. For point 2. There has been some precedent of Europe helping to guarantee sovereign debt. Additional the ECB has been buying some sovereign debt to help reduce pressure on the interest rates.

With regards to point three while a 5% deflation rate is not likely to be seen in the CPI, asset prices have fallen significantly since the downturn. Stock market valuations (adjusted for inflation) have not fallen to the lows of the 80s and as the baby-boomers start to draw down their retirement assets there will be further downward pressure on asset valuations.

http://modeledbehavior.com/2011/02/22/the-401k-pyramid/

MarcoD

I think all the facts can be derived from the following table:



The 'red' countries are in problems, Germany and France pretend that they are trying to fix things, which can't be true since their debt cannot run higher. Moreover, Europe can be damned glad with the former eastern bloc countries, who have low debt and a lot of room for growth.

Greece was never a problem (in the sense that I imagine the rest of the EU is more worried about their own debt), Spain cannot possibly be a problem, it is Italy and worst case France and Germany themselves which are the problem.

MarcoD

1) It may happen, but it is unlikely, Italy can even sustain 7% several years. 2) Can't really happen, they can take over some of the debt, but not all. 3) I think you mean inflation? My guess is that inflation is probably the worst which can happen; it will deflate the debt burden a bit, but at the cost of increasing the interest rates when rolling over the debt and evaporating Northern European investments.

If you look at the European figures of the previous post, the problem just isn't that big at the moment to start the money printing presses - and some of the Northern European countries will be very upset if the ECB starts doing that; I doubt it will happen. It is mostly sentiment which says that Europe is in a bad shape which, unfortunately, is also a hard economic fact.

The problem is the Italian government. They have been unable, under Berlusconi, to implement market reforms and austerity measures to get the Italian debt lower. In fact, they have seemed to have done the opposite the last decade. Now they have to, but it may be too little, too late, for market sentiment.

AlephZero

That is very unlikely under any set of assumptions. The only way to sustain debt in the long term is for the economy to grow faster than the debt interest rate, (and allowing for inflation). The Eurozone strategy on inflation is to keep it low (say less than 3%). The long term growth rate of the Italian economy has been less than 1%. So the debt is sustainable if 3+1 > 7. Financial engineers spend their working lives redefining the rules of arithmetic, but that's a tough one even for them to justify.

MarcoD

I agree with that, the debt would grow under these circumstances. But it can grow to, say, a 140% GDP before the government would go bankrupt. It ain't nice, but they could do that for a few years, if they would find a way out meantime.

[ The thing with Italy is that they have the money, they just don't tax enough. ]

[ Of course, I am Dutch. My best guess is that a combination of austerity in Italy and not starting the money presses is the best for the Netherlands, and probably most of the Scandinavian countries. The French, Germans, and Brits may disagree, though, not sure. ]