Athens and Rome Expose Europe’s Greatest Faultlines

Italy has €200 billion in non-performing loans, plus another €150bn of troubled debt. It has no productivity growth for 15 years, through its own fault.

As one might expect under such conditions, prime minister Matteo Renzi has openly attacked the policies of the EU on numerous fronts including energy, Russia, fiscal deficits, and German dominance of the entire apparatus.

How much longer can this go on before a Eurosceptic opposition party gains control?

Italy’s long-term sustainability in the eurozone is just as uncertain as that of Greece,” says Financial Times writer Wolfgang Münchau in his article Athens and Rome Expose Europe’s Greatest Faultlines.

How should we think about systemic risk in Europe today?

You can see the problem most clearly in Greece — a country battling both an economic meltdown and a refugee crisis — with not much help from the rest of the EU.

Greece may be the starkest example, but it is not the only country facing overlapping crises. It is not even the most important one facing this dilemma. That would be Italy. While Rome’s problems are different from those of Greece, the country’s long-term sustainability in the eurozone is just as uncertain, unless you believe that its economic performance will miraculously improve when there is no reason why it should.

Italy was overwhelmed by the increase of refugees from north Africa last year. On top of that it faces unresolved economic problems — no productivity growth for 15 years; a large stock of public sector debt that leaves the government with virtually no fiscal room for manoeuvre; and a banking system with €200bn in non-performing loans, plus another €150bn of debt classified as troubled. Then consider that its three main opposition parties have, at one time or another, all questioned the country’s membership of the eurozone.

Last week, the Italian government and the European Commission agreed a convoluted scheme to relieve the Italian banking system of some of these toxic assets. It uses all the dirty tricks of modern finance, including the infamous credit default swap, a financial product that mimics insurance against default on a bond, which was particularly popular during the pre-2007 credit bubble. These instruments allow investors to hedge against default risk. But more often than not, their true purpose is to conceal information, to fool investors, or to circumvent regulatory restrictions.

There are no such evil motivations behind this structure in the case of Italy, but the idea that the country’s solvency crisis could be fixed through financial trickery is, of course, absurd. For me the scheme is less a symbol of devious financial engineering, than a sign of desperation.

There are signs that Italy’s patience with the EU and Germany, in particular, is wearing thin. Matteo Renzi, prime minister, has been openly attacking the policies of the EU on energy, on Russia, on the fiscal deficits, as well as German dominance of the entire apparatus.

It is not the euro crisis alone that has brought Italy to the brink of questioning its position in the eurozone. It is a combination of many crises and is likely to gain more momentum from the Brexit debate.

Europe’s policy of muddling through, of doing the minimum required, and hoping to mop up the rubble later, might even have worked if the refugees had stayed at home. The EU’s mistake was not to have chosen a path that would lead to invariable ruin, but to render itself defenseless against the next unforeseen shock.

Excellent Synopsis

That’s an excellent synopsis, with a questionable conclusion. Italy has done virtually nothing to fix its productivity problems, its massive public bureaucracy, or its banking woes.

On the latter point, Italy cannot fix its banking problems because of EU rules. But if it could fix via the bad bank mechanism it wanted, it would have been at taxpayer bail-in expense.

Italian and German Taxpayers Will Foot the Cleanup Bill

One way or another, taxpayers will pay. When Italy has finally had enough with the Eurozone and returns to the Lira, Italian taxpayers will pay via inflation.

It won’t just be Italian taxpayers on the hook. German taxpayers (remaining Eurozone taxpayers in general), will get repaid in Lira for debts owed in Euros. Target2 imbalances ensure that result.

The final result will be a very destructive breakup of the eurozone. The only possible way to avoid that dire result would be for Germany to leave the Eurozone first.

Mike “Mish” Shedlock