Why Italy Is So Scary
Wednesday, November 9, 2011
Italy crossed into bailout territory today. The interest rate on the country's 10-year bonds, which has gone through the roof in the past few weeks, rose to over 7 percent.
We've seen this story play out before in other European countries.
A country is in debt trouble. Investors demand higher interest rates to lend money to that country. Paying those higher interest rates mean the country will fall even further into debt. So interest rates go up even more.
This is why the European Union has intervened with bailout loans for other European countries. The idea: Give the countries loans at lower-than-market rates, so they'll have time to get their fiscal act together. That didn't work for Greece (which had problems too deep to be solved by bailout loans), but it may yet work for Ireland.
And it might work for Italy, which would actually be running a budget surplus if it didn't have to pay interest on its debt. But there's one huge problem: Europe doesn't have enough money in its bailout fund to credibly bail out Italy. That's because Italy's economy — and its debt, in absolute terms — is so much larger than those of the other troubled European countries.
The massive size of Italy's debt means that if the country does wind up unable to pay its bills, the repercussions could be enormous, rippling through the financial system in Europe and in the U.S. American banks are more exposed to Italy than to any other country in the euro zone.
This is not lost on the leaders of Europe. It's why the latest big Euro-deal included a provision to dramatically expand the bailout fund. But European governments weren't willing to put themselves on the hook for that expansion. Instead, they're relying on various forms of financial engineering that are dependent on outside investors.
What's more, Europe is still trying to work out the details of how to do this. And it's likely to be several weeks at least before the new, bigger bailout fund is ready to go.
That leaves the European Central Bank. The ECB has been buying some Italian bonds on the open market. Many observers have said the central bank should go further, announcing that it will buy up as many Italian bonds as necessary to keep interest rates below a certain threshold, to prevent Italy's debt from spiraling out of control.
But Mario Draghi, the new head of the ECB, recently called the bond-buying program "limited" and "temporary." That doesn't sound like what you say if you're about to announce an massive commitment to buy up Italian bonds.