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| Euro photo via Shutterstock |
Italy looks like it won't be able to meet the payments on its outstanding government bonds if interest rates on them rise much higher than 7% - and the shakier the government looks, the more people will dump the bonds, and thus the higher the interest rate will go. This is a clear case of a self fulfilling fear/prophecy (i.e., the more paranoid you are, the more afraid you should be that the feared outcome might just happen).
What is excruciating is the knowledge that stopping the run, and saving the Euro zone, would be easy and relatively costless. In fact, the European Central Bank (ECB) could probably make a profit. It may seem too easy, but all the ECB has to do is to say that they stand ready to buy any and all Italian government bonds. Doing this would immediately erase any fear bond holders have of not being paid, and it would stop the run to dump the bonds dead in its tracks because everyone knows the ECB can buy literally infinite amounts of bonds if it wants to.
Paradoxically, simply SAYING they stand ready to buy any and all Italian government bonds means that they likely won't actually have to DO it. If bond holders' fears are calmed then they won't want to sell the bonds and the ECB won't have to buy them .
This is exactly what the Federal Reserve does in the US for our own government bonds. and it is why the Treasury can borrow at extremely low interest rates. People are happy to have our bonds because they know the Fed stands behind them, so the Fed doesn't actually have to hoover them all up to prop up confidence. Why won't the ECB just do the same thing?
The short answer comes in two parts.
First is a misguided fear of inflation. If anybody can find any evidence of any inflation in any data from anywhere please send me a news flash. It just isn't there and won't be so long as we are in a recession. And if inflation ever does get going, we can easily squash it since with interest rates near zero there is plenty of room to raise them. I know, I know, the German bankers have a fear of inflation burned so deeply into their brainstems that they can't help themselves, but really, the 1920's hyperinflation that caused this attitude is almost a century ago by now, and Germany is supposed to be the central core of the Euro zone. So perhaps they can try to adapt just a bit to modern realities.
The second problem is a political one. The German electorate doesn't want to spend a penny to "bail out" what they see as free-spending Italians (or Spaniards or Portuguese for that matter). But their lack of faith is more a CAUSE of the Italians' problems than a reaction to it. If the Germans were WILLING to bail them out, then they wouldn't have to actually do it, as explained above. And if they did go ahead and buy some Italian government bonds to show they meant business, then they would be able to make a profit on them once it became clear that nobody needs to be afraid of a default.
Why should Americans care? Because a major default on Italian bonds will almost inevitably cause major bank failures in Italy. And Italian bank failures are very likely to cascade into generalized failures across Europe, since not only do many banks hold Italian debt, but many of those Italian banks are counterparties to a myriad of other transactions with other banks in Europe. The banking system is extremely interconnected on many levels. And there is no reason to imagine the cascade will stop there. US banks are also exposed to European debt and European banks - the more European banks that fail, the more the effects ripple out in all directions including our own.
Here is a fear from my own reptile brain. Most folks don't remember, but the major bank-runs in the depths of the Great Depression started in Europe, Austria to be exact. Then they spread from there across the globe, culminating here in FDR's Bank Holiday in March of 1933, when all banks were closed for a period and reopened under a Federal Reserve guarantee of unlimited cash to prop them up. (Which turned out not to be needed since people believed the Fed would do it if they had to. Sound familiar?)
Well, our economies are a LOT more interconnected now than they were in the 1930's. Many of our own banks are exposed to European debt and are parties to millions of transactions a day involving Europeans. Unravelling it all would be a nightmare. The Fed would likely have to step in to prop up some of our banks (yet again), and in fact the Fed is already talking about propping up THEIR banks as a first line of defense. Simply calling a halt for a while as FDR did in the 1930's is hard to imagine nowadays, given the penetration of finance into virtually every part of life. The chances that a general meltdown could happen before it could be stopped are large enough for us to want to prevent such a scenario from even starting. So please, European Central Bank, pretty please won't you do it? It would be very easy.
And if the ECB doesnt? If they simply won't provide the central bank functions and monetary policy the Euro zone so desperately needs? Well, then we will see the the zone breakup so that countries like Italy can have their own currency, their own central bank, and their own monetary policy. Whether that can happen without large bank failures is anyone's guess. But what is certain is that we Americans won't be immune from the fallout.
