The Tragedy Of The Euro

Italy’s finances have many similarities with those of pre-crisis Greece, fuelled by the suppression of borrowing costs until the music stopped in the wake of Lehman. Despite voter rebellions at successive general elections, Italy’s problems are yet to descend into a Greek-style crisis, but that is the direction of travel. And Italy is far more serious than Greece because of its sheer size.

Furthermore, the era of resolving funding problems in government finances by central banks simply printing more money has ended, and global base money worldwide is contracting. Monetary expansion was how the ECB kept bond prices up and deferred unresolved problems. From this month there will be no more asset purchases, so borrowing costs for Eurozone governments are sure to rise from extremely low interest rates.

The more one considers the outlook for the Eurozone, the riskier it appears. Until it ceased in December, about €2,500bn has been invested in government bonds by the ECB. In effect, the ECB has engineered a second period of rate convergence, this time almost exclusively for Eurozone governments, while ignoring commercial interests. The lesson from the first period is it will be followed by a destructive period of rate divergence when the ECB’s steps out of the market, which it now has. Commercial banks have also been supporting their national governments despite artificially low yields, in the knowledge the ECB was underwriting bond prices.

Now that the ECB’s support for bond markets has ceased, either governments collectively stop running budget deficits, or they will have to be funded by other means. They are almost certainly not going to reduce their collective demand for more funds as the Eurozone slips into recession and rates rise against them.

Commercial banks will have to come to terms with the new reality. Having seen euro-bond yields converge then diverge in the first phase of the euro’s life, we are now seeing them diverge again. And as they diverge yet more, confidence that the Euro-system and the politicians at the centre have control of events will quickly erode, as they did last time.

In this context, the Eurozone’s track record of non-adaptability to changing market conditions is worrying. It leaves the prices of longer-term debt somewhat adrift, lacking natural buyers without a sharp steepening of yield curves. A buyers’ strike is beginning to look best-case, which brings us to the greatest risk of all, the pressure on bank credit to contract as banks attempt to reduce their exposure to falling government bond prices in order to preserve their capital.

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