Is the Euro well and truly buggered?

Even the stock market rises on the news of Berlusconi's resignation.
Whoever will replace him, I have sympathy for. Berlusconi will leave his successor not only a fiscal disaster...

Ther's a huge difference between our debt and Greece. Greece has no way to pay their current debt; our political system and economy provides us with many options. Not many people believes Egypt can pay their debt; many investors from around the world still buy US bonds.

Here’s how it was supposed to go: Greece first. Then, perhaps, Portugal and Ireland. If things got really bad, Spain. If the world -- or, more precisely, the euro -- was coming to an end, Italy. It was not supposed to go Greece and then Italy. No one was prepared for that. The markets weren’t prepared for that.


And so the markets are falling. The Dow is down 290 points. The Stoxx 50, a blue-chip index for the euro zone, is down 2.5 percent. Italy’s borrowing costs have skyrocketed. The Euro has plunged.

The problem, put simply, is that Italy is both too big to fail and too big to save. It’s the eighth-largest economy in the world. At $2 trillion, it’s about seven times as large as Greece’s $300 billion economy. France and Germany’s banks alone have $600 billion in exposure to Italian debt. But Barclay’s says Italy is “now mathematically beyond the point of no return.” Silvio Berlusconi might be out, but changing governments does not change arithmetic. And so the question is simple, and stark: If there wasn’t the will to really save Greece, where would the will -- and the money -- come from to save Italy?

The risk of contagion has become a reality with Italy, which does pose systemic risk, now seeing borrowing costs surge to unsustainable levels. But it’s not a done deal. Rosenberg notes that “ratings downgrades could come next. And after Italy, the bond vigilantes could come after France and if that happens, we may all kiss the EFSF goodbye unless the Germans opt to Finance a continent-wide bailout on its own.” France’s largest banks, BNP Paribas and Credit Agricole, hold a combined $416.4 billion in Italian private and public debt as of June, according to Bloomberg. France’s precarious AAA credit rating is under close scrutiny by credit rating agencies and a downgrade would put massive pressure on the EFSF and its AAA rating, which is only as strong as its weakest link. Back in Rome, Italian President Giorgio Napolitano, the head of state, was forced to release a statement aimed at calming financial markets given the “alarming state” of Italian bond yields. Napolitano said there was no doubt Berlusconi would quit after the “Stability Laws” were put in place, which would be approved within a few days. While Napolitano said that he can adopt emergency measures at a moment’s notice, Bloomberg reported that legislators haven’t even received the austerity bill they are supposed to begin debating on November 16. Furthermore, Barclays adds that even if legislators pass the “Stability Laws,” two weeks is by no means enough time for Italian policymakers to get it right. “In our view, though, two weeks is too short a time to approve comprehensive measures as required by EU partners, in particular those related to labor market, privatizations and liberalization. As also suggested in a letter sent to Italy by the European Commission, the plan presented to the EU summit lacks details about timing and implementation of key measures,” wrote the analyst. The impact of Europe’s sovereign debt crisis stretches well beyond Europe, though, and will affect companies on this side of the pond. General Motors’ Wednesday earnings release illustrated the company’s ongoing concern with Europe, and Ford, as I reported on Tuesday, has substantial sales exposure to the Old Continent. Even traditionally defensive stocks like Coca Cola and General Electric, register large revenue risk stemming from their European operations. If Italy were to default, the fallout would be devastating for Europe and the global economy.

SILVIO BERLUSCONI'S promise to resign has done nothing to calm European bond markets. Italian bond yields are soaring today; both the two-year and the ten-year are above 7%. There are rumours that the ECB is in the market and buying heavily. If so, it's not having the desired effect. The ECB can't hope to keep yields reasonable through brute force. It will need to make an expectations-changing announcement. Will it? Italy's yields aren't the only ones rising. Markets are ditching Irish, Spanish, Belgian, and French debt too. The ten-year Treasury is back below 2%.

Yesterday, I wondered why equities weren't falling. Today, they are. But I think Tim Duy is on to something here:

All I can say is that we have been here before. Recall 2007...By the middle of 2007 the TED spread was exploding, signaling enormous financial turmoil. Yet equities kept heading upward, fueled by data that was just not that bad coupled with ongoing expectations that a solution was just around the corner. And now we find ourselves in almost the exact same position...the news out of Europe is abysmal...There is no solution, no magic summit at hand. At this point, it is a choice between severe recession and depression. There is no happy ending to this story.

I have been examining and re-examining the situation, trying to find the potential happy ending. It isn't there. The euro zone is in a death spiral. Markets are abandoning the periphery, including Italy, which is the world's eighth largest economy and third largest bond market. This is triggering margin calls and leading banks to pull credit from the European market. This, in turn, is damaging the European economy, which is already being squeezed by the austerity programmes adopted in every large euro-zone economy. A weakening economy will damage revenues, undermining efforts at fiscal consolidation, further driving away investors and potentially triggering more austerity. The cycle will continue until something breaks. Eventually, one economy or another will face a true bank run and severe capital flight and will be forced to adopt capital controls. At that point, it will effectively be out of the euro area. What happens next isn't clear, but it's unlikely to be pretty.

Can this cycle be interrupted? I think so. I think that an ECB guarantee to backstop sovereign debt, coupled with massive purchases to establish credibility and a substantial easing in monetary policy, could change the dynamic, particularly if quickly followed up with a major fiscal commitment from core economies to support bail-out efforts and invest in peripheral economies while peripheral economies focus on substantial labour market, public-sector, and tax reforms. How likely does all of that sound? Could the ECB even commit to the above bold actions without facing debilitating criticism, and perhaps intervention, from national governments?

I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can't believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur. And I still don't understand why, if this is all as obvious as it seems to me, equities aren't down 20% now, rather than 2% or 3%. But the window within which something could be done to prevent it is closing, and fast. I hope to be proven astoundingly wrong in my assessment, but I'm struggling to see alternative outcomes

Particularly remarkable are some of the comments attributed to Deutsche Bank’s chief economist, Thomas Mayer. In talks with Ambassador Murphy he mentioned the possibility of Germany leaving the euro zone.
He was apparently basing his remarks on a 1990s decision taken by Germany’s Constitutional Court, which ruled it would be possible for Germany to leave “if the currency union were to become an inflation zone” or the German taxpayer a “de facto rescuer

Things have changed since. After the last EU summit a number of signs pointed to the possibility of Greece being the first euro zone country to come under economic guardianship.

Reading and comprehending are two different things.

Three realities define Europe’s situation.

First, the crisis is as much political and social as it is economic. The “European model” of generous social benefits and secure jobs is besieged. Welfare states have become too costly for many countries’ economies to support. Benefits must be curtailed. The austerity now being imposed or recommended inflicts direct hardship and assaults beliefs and expectations that have been nurtured for decades.

Second, Europe can no longer rescue itself. There are too many potentially needy debtors and too few credible lenders. The main rescue mechanism — the European Financial Stability Facility (EFSF) — has already committed about 250 billion euros of its 440 billion euros to Greece, Ireland and Portugal, reports the Institute of International Finance, an industry group (and the source of most data cited here). Even an expanded EFSF probably couldn’t handle Italy and certainly not Spain and France. The European Central Bank — Europe’s Federal Reserve — could buy unlimited amounts of government bonds. But it has so far disdained this role, fearing the inflationary consequences.

Finally, the IMF is in no position today to rescue Europe. At last count, it had about $400 billion in available funds. This wouldn’t cover Italy’s refinancing needs for a year. So the IMF needs more money.

PARIS - In Europe, investors are running the show. They have the ability to steer a country’s conduct of economic affairs and to make or unmake governments. What used to be the purview of the sovereign people of a nation have now passed into the hands of a few who trade on global markets.
The most recent example is the successful financial coup in Italy. In spite of countless attempts, neither prosecutors nor Italian public opinion had managed to get Silvio Berlusconi to leave office. All the financial markets needed was a few days of heavy pressure on the rates of the Italian debt. Now trusted former European Union Commissioner Mario Monti has stepped into Berlusconi's spot, in large part in the hopes that it will calm investor worries.
The scalp of the Italian executive was added to those of the heads of the Greek, Irish and Portuguese governments. And a new austerity plan is soon going to expand a growing list. Like it or not, politics in Europe are now taking place in the trash heap of the economic crisis.
How did it get so bad? Without coercion or conspiracy, governments gradually abandoned the reins of power to Europe’s creditors. The turning point happened in March 2005, when instead of going on a diet, France and Germany put pressure on the EU Council to relax the rules of the European Stability and Growth Pact, which they deemed too inflexible and ultimately unenforceable.
A door was thus opened to allow public finances across the euro zone to start sliding. Since then, deficits and debts have continued to grow, greatly increased by the crisis of 2008-2009. As a result, the House of Europe has changed hands. And its new owner is worried about paying the rent. Such anxiety can be seen as blown out of proportion.
However, some European members are so desperate that they have no choice but to give guarantees to their creditors. For Europe, decision time has come. It can no longer walk the path it has followed so far, simply transferring pressure from its investors onto its most indebted member states, just in order to keep up appearances.
The situation in Italy struck a blow in the heart of Europe. And as things stand, the vortex could soon sweep away Belgium, or even France, judging by the evolution of their interest rates. Regaining control means moving towards federalism as soon as possible. This too will obviously involve a significant loss in terms of sovereignty. But the sacrifice is actually not that great, because that same sovereignty has now become virtual -- and subject to the will of investors.