Italy and the Fate of the Euro

Italian Prime Minister Silvio Berlusconi offered to resign on Tuesday, and world markets rallied.  Stocks, commodities, and the embattled euro all enjoyed healthy gains.  With that rascally charlatan out of the way, Italy could get finally serious about its economic reforms and the rest of Europe could get serious about resolving the sovereign debt crisis.

Che cosa?

Or maybe not.  Wednesday, one day later, saw one of the biggest selloffs of 2011 due in part to fears that Mr. Berlusconi's absence created political uncertainty and a power vacuum.  The spark that prompted the crash was news that European clearing houses were raising margin requirements on Italian bonds.  Italian 10-year bond yields rose about 7 percent—the level at which Greece, Ireland, and Portugal had to be bailed out—leaving investors to ponder existential questions about the euro itself.  Not only was Italy too big to fail, it was too big to bail.  Stocks, commodities, the euro, and even gold—that supposed “crisis hedge”—all saw substantial losses.

And then, Thursday, all was well in the world again.  Italy sold new bonds at lower yields than expected, there was a new prime minister waiting in the wings, and stocks, commodities and the euro rallied.

If this brief history of the last week made no sense to you, don't feel bad.  That just means you're thinking logically.  And there is nothing logical about the currency and sovereign debt markets.

Italy's debt burden is well known.  The country's debt currently stands at 120 percent of GDP.  No wonder the country is viewed as a threat to European financial stability.

Yet Italy is actually one of the strongest economies in Europe.  Yes, you read that right.  The Italian banking system avoided most of the turmoil of recent years, and Italy runs a primary budget surplus. (This means that Italy's budget is in surplus before interest payments on existing debt.)

Let's compare this to a supposed safe haven country—Japan.

Japan's debts are well in excess of 200 percent of GDP—by far the highest in the G20—and the country is adding to that debt at an alarming rate.  Japan's budget deficit is projected to be 10 percent of GDP this year.  Yet Japan has actually had to intervene recently to force the price of the yen down.  Traders can't seem to get their hands on enough yen, and the Japanese 10-year bond yields a shockingly low 1 percent.

This is no defense of Italy, of course.  Frankly, if the bond market vigilantes are doing their jobs, Italian bonds should trade at substantial premiums to those of their northern European neighbors.  But where were these vigilantes over the past decade?  And why are they not currently punishing Japan?

Don't ask why, dear reader.  It's like trying to understand the fashion trends of teenagers.  There is no answer.

The Italian crisis is a bit of a self-fulfilling prophecy.  After watching Greece implode, bond traders fear that Italy will be next.  So they sell Italian bonds in anticipation, which causes yields to rise and makes it difficult for Italy to pay its bills—thus creating the very crisis they feared.

Dr. Doom

So, with all of this as a very long introduction, let's see what “Dr. Doom” has to say about Europe and the euro.  In a new paper (see “Four Options to Address the Eurozone's Stock and Flow Imbalances: The Rising Risk of a Disorderly Break-Up”), Nouriel Roubini offers four sets of policy options:

1. Growth and competiveness are restored through aggressive monetary easing, a weaker euro and fiscal easing in the core (i.e. Germany), while the periphery states (Greece, Italy, Spain, etc.) undergo fiscal austerity and structural reforms.  The euro survives, with perhaps a few defections.
2. A deflationary/depressionary adjustment that pushes down wages and prices to regain competitiveness. Growth is depressed for many years.  This is what Germany advocates and what we are seeing today.
3. The core permanently subsidizes the periphery—via both debt reduction and bailouts.
4. The eurozone sees widespread debt restructurings and eventually breaks up to restore competitiveness.

These four options can lead to three possible outcomes.  The first—to which normally bearish Roubini assigns a surprisingly high 40 percent likelihood—is that everything in policy option one goes as planned, Italy and Spain return to growth, and all is well in the world.  Roubini assigns a 50 percent probability that not much of anything gets done, we muddle along in a fragile status quo for another year, and a muddled mix of policy options two and three become the de facto non-decision decision.  Roubini puts the odds of widespread default and Eurozone disintegration at 10 percent.

Figure 1

One point should be immediately clear.  None of these options bodes well for the price of the euro, which remains surprisingly expensive at present (see Figure 1).  Monetary easing by the European Central Bank—including, but not limited to, lowering the benchmark rate and aggressively buying Italian and Spanish bonds— should cause the euro to fall against the dollar and other major currencies.  In fact, the euro's surprising strength vis-à-vis the dollar is largely due to the ECB's hawkishness relative to the Fed.

Because options two and three carry significant political risk and virtually guarantee that this crisis will linger for years into the future, these two scenarios should also be bearish for the euro.  And clearly, option four, in which the Eurozone may cease to exist in anything resembling its current form, would be catastrophic to the value of the common currency.

John Maynard Keynes famously said that the market can remain irrational longer than you can remain solvent, and nowhere does this hold truer than in the world of currency trading.  Still, investors willing to brave the currency minefield should consider the euro as a possible short.  As Figure 1 makes abundantly clear, the euro can defy its critics for months at a time, particularly given how unappealing its primary competitors—the dollar and yen—are.  But the overall direction over the next several years should be down.

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