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Confidence tricks

23 Jul 2012 By Hugo Dixon

The euro crisis is to a great extent a confidence crisis. Sure, there are big underlying problems such as excessive debt and lack of competitiveness in the peripheral economies. But these can be addressed and, to some extent, this is happening already. Meanwhile, a quick fix for the confidence crisis is needed.

The harsh medicine of reform is required but is undermining confidence on multiple levels. Businesses, bankers, ordinary citizens and politicians are losing faith in both the immediate economic future and the whole single-currency project. That is creating interconnected vicious spirals.

The twin epicentres of the crisis are Spain and Italy. The boost they received from last month’s euro zone summit has been more than wiped out. Spanish 10-year bond yields equalled their euro-era record of 7.3 percent on July 20; Italy’s had also rebounded to a slightly less terrifying but still worrying 6.2 percent.

As ever, the explanation is that the summiteers came up with only a partial solution and even that was hedged with caveats. Although the euro zone will probably inject capital into Spain’s bust banks, relieving Madrid of the cost of doing so, the path will be tortuous. Meanwhile, a scheme which could help Italy finance its debt will come with strings attached – and there still isn’t enough money in the euro zone’s bailout fund to do this for more than a short time.

The two countries’ high bond yields aren’t just a thermometer of how sick they are. They push up the cost of capital for everybody in Spain and Italy, while sowing doubts about whether the whole show can be kept on the road. Capital flight continues at an alarming rate, especially in Spain. The so-called Target 2 imbalances, which measure the credits and debits of national central banks within the euro zone, are a good proxy for this. Spain’s Target 2 debt had grown to 408 billion euros at the end of June, up from 303 billion only two months earlier. The Italian one was roughly stable but still high at 272 billion euros.

The loss of confidence is harming the economy. Spain’s GDP is expected to shrink by 2.1 percent this year and a further 3.1 percent next year, according to Citigroup, one of the more pessimistic forecasters. The prospects for Italy are not much better: a predicted 2.6 percent decline this year followed by 2 percent next year.

Shrinking economies are, in turn, pushing up debt/GDP ratios. Citigroup expects Spain’s to jump from 69 percent at the end of last year to 101 percent at the end of 2013, in part because of the cost of bailing out its banks, while Italy’s will shoot up from 120 percent to 135 percent. These eye-popping numbers then reinforce anxiety in the markets.

All of this is having a corrosive effect on the political landscape. In Italy, the situation is especially precarious as Mario Monti, the technocratic prime minister, has repeatedly said he will resign after next spring’s elections. The centre-left Democratic Party, which is leading in the opinion polls, is still committed to the euro. But the second and third most popular political groups – the Five Star movement led by comedian Beppe Grillo, and Silvio Berlusconi’s PdL – are either outright eurosceptics or toying with becoming so.

The situation is slightly better in Spain because Mariano Rajoy has a solid majority and doesn’t officially have to face the electorate for three and a half years. But hundreds of thousands of demonstrators took to the streets last week to protest against the latest austerity measures. Pundits are starting to speculate that Rajoy may not last his full term. And if the Italian and Spanish governments can’t carry their people with them along the reform path, the fear is that Germany may no longer support them.

High borrowing costs, capital flight, and economic and political weakness: to escape this vortex, the immediate priority is to get Spain’s and Italy’s bond yields back down. The goal should be to cut borrowing costs below 5 percent – a level that would no longer be that worrying. While most of the ways of doing this have been vetoed by Germany, at least two haven’t.

One is to leverage up the European Stability Mechanism, the region’s bailout fund, so that it has enough money to fund both Madrid and Rome. Neither Germany nor the European Central Bank want to let the ESM borrow money from the ECB itself. But what about lifting the cap on how much it can borrow from the market?

Another option would be for the core countries, led by Germany and France, to subsidise Spain’s and Italy’s interest rates directly – giving back to the southern Europeans part of the benefit they are enjoying from their own extremely low borrowing costs. If they agreed to close half the gap between the core and the periphery, such a scheme would cost around 75 billion euros over seven years, according to a Breakingviews’ calculation. An interest-rate subsidy would also give markets the confidence that Madrid and Rome would be able to finance their debts and so could further lower their borrowing costs.

There would, of course, have to be conditions. In Italy, Monti needs to embark on a second wave of reforms. In particular, he should launch a mass multi-year privatisation programme and a big one-off wealth tax to cut Italy’s debt. But after Spain’s recent plan to clean up its banking sector and further tighten its belt, there is little more to be asked of it.

Germany is right to insist on reforms. But it should balance the stick with a bigger carrot. Otherwise, the single currency from which it benefits so much could collapse.


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