Wednesday, November 23, 2011

Is The Italian Crisis A Possible Self-Fulfilling Prophetic Negative Bubble?

Many observers are declaring Italy to be the key to whether the euro will collapse and along with it possibly most of the world economy. Having removed the near term problem from office, Silvio Berlusconi, the markets are not satisfied with the appointment of respected economist technocrat, Mario Monti, to replace him, with bond yields continuing to rise, thus threatening to bring about a crisis. What is it that Monti is or even can do to stop this?

Quite likely not a damned thing. Looking at supposed fundamentals, there should not be a problem with Italy. It is one of only four Eurozone nations that is currently running a primary budget surplus. The others are Luxembourg, Belgium, and Germany. Where is the problem?

Well, some say, aha!, look at the national debt to GDP ratio, a too high 120%. However, not only has Italy had a ratio such as this for a long time, and even been higher prevously, such as in the early 1990s, it has a much higher share of its debt domestically held, Italy has a much higher savings rate than most European nations (on the order of 17%). This would explain the NY Times story today that as long as Italians continue to hold their own debt, the euro will be saved.

What about proposals being made in Italy? One is that the retirement age be raised from 65 to 67. Maybe this should be done, but again, Italy has a primary budget surplus, and 65 is higher than quite a few other European nations have as a retirement age. And if such a "reform" is passed, it will have little near term impact on the budget balance, although maybe doing so will induce that magic effect of "raising confidence," thus bringing down the interest rates.

The other is labor market reforms, particularly to open up various professions to more entry and competition. This will be hard to pass, but I think there may be reasons for doing this, and this may well help increase the growth rate, which has been low for a solid decade, and needs some stimulus, however achieved. But, again, this is not likely to affect the budget balance at all. Why this would bring down overly high interest rates is also very unclear aside from hoping for the "confidence fairy" to suddenly appear.

That the confidence fairy has not appeared with the removal of Berlusconi is disturbing. It looks increasinigly to me that these high interest rates are simply a self-fulfilling negative bubble on Italian bonds unjustified by any actual fundamental phenomena. Even with the high interest rates, most reports suggest that Italy can manage to avoid any defaults for at least another year. It is not Greece, or even the less troubled Portugal, Ireland, or Spain. It is basically solvent. The only real threat is the high interest rates, apparently existing because of the fear of what high interest rates can do, a possible self-fulfilling prophecy, an empty, if still dangerous negative bubble.


Post a Comment