While everyone’s moved on to Italy, and I’ll get there in a moment, let’s linger for a while over Greece, long enough to note that the country still doesn’t have a Prime Minister, as the hand-picked caretaker has annoyingly decided that he actually wants the power of the office rather than just sit in the chair while the international community tells him what to do. How rude!
Now let’s move on, because the Italian crisis is a ticking neutron bomb. The bond markets have pushed up Italian debt yields close to the supposed fail-safe point of 7% — the level at which experts say Italy can’t sustain its debt payments — that would signal the need for intervention by the European Central Bank or the IMF. At last count, the debt yield peaked at 6.74% before falling back a bit. The higher cost of borrowing could lead to Italy not having the money required to pay it, leading to default. But as Paul Krugman writes, as important as the bond yield is, the marginal lenders are also a factor:
I would consider the margin question part of a broader issue, which I think of as Shleifer-Vishny, after their classic paper on the limits of arbitrage (pdf). Their point was that a fall in the price of some asset, even if it should in principle present a buying opportunity if the fundamentals haven’t changed, may actually be self-reinforcing instead if there is a limited class of leveraged investors who buy that asset. Why? Because the capital losses those investors suffer may force them to pull back instead of piling in.
I can see this happening here. Most Italian debt may be held by stolid domestic players, but at the margin are financial institutions that are quite possibly going to be forced to cut their holdings if Italian interest rates rise, because this will reduce the value of the bonds they already hold. So things could quite possibly go blooey in the very near future.
This has become a political crisis as much as an economic crisis. There’s an Italian Parliamentary vote on a routine budget bill today, one that failed to get a majority last month. They were able to pass it today, but without a majority, with 308 voting yes and 321 abstaining. Silvio Berlusconi’s shaky coalition is clearly seen by the international community as a liability, and that’s part of what’s pushing up bond rates. A key member of the coalition called for Berlusconi to step down:
Silvio Berlusconi’s main coalition partner Umberto Bossi of the Northern League has called on the embattled prime minister to step down and make way for the former justice minister Angelino Alfano.
Bossi told reporters that ‘we asked the prime minister to step down,’ as the political uncertainty in Italy has sent the cost of government borrowing soaring.
I have no love for Berlusconi, but his sin here is not being able to institute austerity measures, euphemistically called “reforms”. That’s not for lack of trying, but Berlusconi cannot deliver because he simply doesn’t have the loyalty of his coalition, who know that following Berlusconi down an unpopular path will be the end of their political careers. This is a problem for the banksters and European leaders, but they cannot bully Berlusconi, or lure him with the promise of filthy lucre and flattering appointments, the way they could former Greek Prime Minister George Papandreou.
The bond yields are rising despite ongoing intervention by the ECB on the secondary market. But more is clearly needed. And the crisis is starting to impact bank lending in the US, which given global interconnectedness was inevitable:
The crisis in Europe has begun to spill over into US bank lending, according to the latest survey of loan officers by the US Federal Reserve.
Credit conditions have steadily eased since the end of the recession but that process almost ground to a halt in the last three months, with only five domestic banks out of 50 saying that they relaxed their standards for lending to large companies. Two banks had tightened conditions.
There was also a sharper retrenchment by US branches of foreign banks: 23 per cent of such operations tightened their lending terms, raising their interest rate spreads and cutting back on the amount and period for which they are willing to lend.
Of the foreign banks that tightened their lending conditions in the US, all nine pointed to a weaker economic outlook, while a majority said they had a lower tolerance for risk, that their own liquidity position was weaker, and that it was harder to sell loans on the secondary market.
More at the NYT. The whole thing has an end-of-the-world quality to it.