{"id":25157,"date":"2011-11-12T12:30:34","date_gmt":"2011-11-12T17:30:34","guid":{"rendered":"http:\/\/countingpips.com\/fx\/2011\/11\/12\/italy-and-the-fate-of-the-euro\/"},"modified":"2011-11-12T12:30:34","modified_gmt":"2011-11-12T17:30:34","slug":"italy-and-the-fate-of-the-euro","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/fx\/2011\/11\/12\/italy-and-the-fate-of-the-euro\/","title":{"rendered":"Italy and the Fate of the Euro"},"content":{"rendered":"

By The Sizemore Letter<\/a><\/p>\n

Italian Prime Minister Silvio Berlusconi offered to resign on Tuesday, and world markets rallied.\u00a0 Stocks, commodities, and the embattled euro all enjoyed healthy gains.\u00a0 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.<\/p>\n

\"\"<\/a><\/p>\n

Che cosa?<\/p>\n<\/div>\n

Or maybe not.\u00a0 Wednesday, one day later, saw one of the biggest selloffs of 2011 due in part to fears that Mr. Berlusconi\u2019s absence created political uncertainty and a power vacuum.\u00a0 The spark that prompted the crash was news that European clearing houses were raising margin requirements on Italian bonds.\u00a0 Italian 10-year bond yields rose about 7 percent\u2014the level at which Greece, Ireland, and Portugal had to be bailed out\u2014leaving investors to ponder existential questions about the euro itself.\u00a0 Not only was Italy too big to fail, it was too big to bail<\/em>.\u00a0 Stocks, commodities, the euro, and even gold\u2014that supposed \u201ccrisis hedge\u201d\u2014all saw substantial losses.<\/p>\n

And then, Thursday, all was well in the world again.\u00a0 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.<\/p>\n

If this brief history of the last week made no sense to you, don\u2019t feel bad.\u00a0 That just means you\u2019re thinking logically.\u00a0 And there is nothing logical about the currency and sovereign debt markets.<\/p>\n

Italy\u2019s debt burden is well known.\u00a0 The country\u2019s debt currently stands at 120 percent of GDP.\u00a0 No wonder the country is viewed as a threat to European financial stability.<\/p>\n

Yet Italy is actually one of the strongest economies in Europe.\u00a0 Yes, you read that right.\u00a0 The Italian banking system avoided most of the turmoil of recent years, and Italy runs a primary budget surplus.<\/em> (This means that Italy\u2019s budget is in surplus before interest payments on existing debt.)<\/p>\n

Let\u2019s compare this to a supposed safe haven country\u2014Japan.<\/p>\n

Japan\u2019s debts are well in excess of 200 percent of GDP\u2014by far the highest in the G20\u2014and the country is adding to that debt at an alarming rate.\u00a0 Japan\u2019s budget deficit is projected to be 10 percent of GDP this year.\u00a0 Yet Japan has actually had to intervene recently to force the price of the yen down<\/em>.\u00a0 Traders can\u2019t seem to get their hands on enough yen, and the Japanese 10-year bond yields a shockingly low 1 percent.<\/p>\n

This is no defense of Italy, of course.\u00a0 Frankly, if the bond market vigilantes are doing their jobs, Italian bonds should<\/em> trade at substantial premiums to those of their northern European neighbors.\u00a0 But where were these vigilantes over the past decade?\u00a0 And why are they not currently punishing Japan?<\/p>\n

Don\u2019t ask why, dear reader.\u00a0 It\u2019s like trying to understand the fashion trends of teenagers.\u00a0 There is no answer.<\/p>\n

The Italian crisis is a bit of a self-fulfilling prophecy.\u00a0 After watching Greece implode, bond traders fear that Italy will be next.\u00a0 So they sell Italian bonds in anticipation, which causes yields to rise and makes it difficult for Italy to pay its bills\u2014thus creating the very crisis they feared.<\/p>\n

\"\"<\/a><\/p>\n

Dr. Doom<\/p>\n<\/div>\n

So, with all of this as a very long introduction, let\u2019s see what \u201cDr. Doom\u201d has to say about Europe and the euro.\u00a0 In a new paper (see \u201cFour Options to Address the Eurozone\u2019s Stock and Flow Imbalances: The Rising Risk of a Disorderly Break-Up<\/a>\u201d), Nouriel Roubini offers four sets of policy options:<\/p>\n

    \n
  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.\u00a0 The euro survives, with perhaps a few defections.<\/li>\n
  2. A deflationary\/depressionary adjustment that pushes down wages and prices to regain competitiveness. Growth is depressed for many years.\u00a0 This is what Germany advocates and what we are seeing today.<\/li>\n
  3. The core permanently subsidizes the periphery\u2014via both debt reduction and bailouts.<\/li>\n
  4. The eurozone sees widespread debt restructurings and eventually breaks up to restore competitiveness.<\/li>\n<\/ol>\n

    These four options can lead to three possible outcomes.\u00a0 The first\u2014to which normally bearish Roubini assigns a surprisingly high 40 percent likelihood\u2014is that everything in policy option one goes as planned, Italy and Spain return to growth, and all is well in the world.\u00a0 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.\u00a0 Roubini puts the odds of widespread default and Eurozone disintegration at 10 percent.<\/p>\n

    \"\"<\/a><\/p>\n

    Figure 1<\/p>\n<\/div>\n

    One point should be immediately clear.\u00a0 None of these options bodes well for the price of the euro, which remains surprisingly expensive at present (see Figure 1<\/strong>).\u00a0 Monetary easing by the European Central Bank\u2014including, but not limited to, lowering the benchmark rate and aggressively buying Italian and Spanish bonds\u2014 should cause the euro to fall against the dollar and other major currencies.\u00a0 In fact, the euro\u2019s surprising strength vis-\u00e0-vis the dollar is largely due to the ECB\u2019s hawkishness relative to the Fed.<\/p>\n

    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.\u00a0 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.<\/p>\n

    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.\u00a0 Still, investors willing to brave the currency minefield should consider the euro as a possible short.\u00a0 As Figure 1 makes abundantly clear, the euro can defy its critics for months at a time, particularly given how unappealing its primary competitors\u2014the dollar and yen\u2014are.\u00a0 But the overall direction over the next several years should be down.<\/p>\n

    If you liked this article by Sizemore Insights<\/em>, you\u2019d probably enjoy The Sizemore Investment Letter<\/em>, our premium members-only newsletter. Click here<\/a> for more information.<\/p>\n","protected":false},"excerpt":{"rendered":"

    By The Sizemore Letter Italian Prime Minister Silvio Berlusconi offered to resign on Tuesday, and world markets rallied.\u00a0 Stocks, commodities, and the embattled euro all enjoyed healthy gains.\u00a0 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 … <\/p>\n

    Continue reading “Italy and the Fate of the Euro”<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[],"tags":[],"class_list":["post-25157","post","type-post","status-publish","format-standard","hentry"],"_links":{"self":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/25157","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/comments?post=25157"}],"version-history":[{"count":0,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/posts\/25157\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/media?parent=25157"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/categories?post=25157"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.investmacro.com\/fx\/wp-json\/wp\/v2\/tags?post=25157"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}