Il Sole 24 Ore

The Edge of the Abyss: Can Restoring Italy's Credibility Spur Eurozone Reform?

Editor's Note: The following is a revised and expanded English version of a column written in Italian by Carlo Bastasin for Il Sole 24 Ore.

It is rare to hear open talk at a global summit of a country’s loss of credibility. And it is painful to observe that today this description, which goes beyond the sphere of economics, regards Italy. There is no doubt that political credibility is the core of the Italian problem at the moment. Requiring certification for government action by both the International Monetary Fund (IMF) and the European Union means that Italy's political ability is indeed the key concern of Italy’s partners, as well as of investors. Policymaking has to be taken away from the internal debate and has to be subject to growing checks and pressure. The sooner the credibility problem of the Italian government is solved, the easier it will be to make self-determination compatible with external discipline or even make the latter redundant.

But while Italians acknowledge and address their political deficiencies, they have the right to ask for a framework of European assistance that is also more solid and more credible than the current one. The system to contain the crisis that the EU summit came up with on October 26 was not feasible, and the G-20 summit highlighted these problems. The Countries that are not part of the Euro Zone have no intention of financing the bailout fund (EFSF) after seeing that even European countries do not want to increase their contribution. Once established that 221 billion euro is the maximum amount of losses that Germany is willing to accept, the leverage and the insurances gimmicks to pump up the EFSF became a game of smoke and mirrors. The real resources available are evidently too few to assist Italy or other large countries.

The reasons for market turbulences have originated elsewhere, but by squandering political credibility, in recent months Rome has lost its capability of funding on the market. Indeed,in the short term even an 8% cost of debt service would be bearable. But if markets are in the least bit rational, in the technical sense, within a few months such a burden becomes unsustainable. With 10-year bonds now bearing real yields of over 5%, Italy would need a "Chinese" style GDP growth of 7%, yet it will be lucky over the next 12-months not to post a contraction. At that point the yield that an investor would ask could increase further, aggravating the spiral. It is no longer useful to distinguish if there is a liquidity or sustainability problem for Italian debt. The Italian situation has to be treated as if a remedy were needed for the two problems: both the funding that the market does not intend to lend and the policy to contain debt; therefore, both external resources and internal reforms.

However not only is the EFSF insufficiently endowed, but even the IMF does not have the huge and immediate resources that could be necessary for Italy. Furthermore, the failure to shore up Greece took the sudden effect of credibility away from the intervention of the IMF and from European authorities. Before markets convince themselves that the reforms in Italy represent a turnaround, they will first want to see the results. Finally, Greece, with the gamble of the referendum, broke the taboo of a possible exit from the euro of one of the 17 countries. Now the table of the crisis is tilted precisely in the direction that up until yesterday everyone denied the existence of. In consideration of Italy’s potential danger for the euro zone, Merkel and Sarkozy should avoid playing with the uncertainty of aid, leaving open scenarios that are so dangerous.

Is the ECB purchase of government bonds the last - and inevitable - resource? Probably it is. But the conditions for that are still far from present. It is really incomprehensible to grab onto the November 3 rate cut to think that the central bank has a more conceding attitude. In terms of contrasting the financial crisis there does not seem to be any change compared with Trichet's macro-prudential stability policy. Since July 2008 the ECB has seen keeping inflation expectations stable as its main contribution towards financial stability, while it has been committed to supplying broad liquidity to the payment system. In light of an expected contraction of GDP like the one forecast for the EU, and also Germany, the ECB's intervention is not in any way a loosening of the grip over inflation.

In fact, with Draghi at the helm, the ECB continues to say that it is reluctant to buy sovereign bonds. The reason is that it wants to avoid a market perception that there is "fiscal dominance" over the central bank and therefore a move towards debt monetization and inflation. Furthermore, the purchase of assets that are not perfectly replaceable, like sovereign bonds of different countries of the euro, has fiscal effects that should be more up to a political authority than a central bank.

All of this is understandable and politically coherent. But today, starting up again the engines of credit in the euro area - bringing back the functionality of the transmission mechanism of monetary policy - means solving the sovereign debt crisis that is obstructing them. European banks are reducing their exposure towards public bonds up to the point that they are jamming the market. Supervisory authorities of Northern countries of the euro area are asking their lenders to reduce exposure especially to Southern European bonds which since recently have a higher risk in the eyes of European authorities. As an example, in three months BNP reduced exposure to Italian bonds by 40%, more or less like ING and Barclays. Since the beginning of the year Deutsche Bank has slashed by 70% its exposure to Southern European bonds. The capital requirements imposed on banks worsens the situation. At a minimum, more coordination among authorities - banking surveillance and the ECB - should be granted.

According to recent data, the ECB has in its portfolio 1.7% of European debt (except for the recent purchases) against 18% of the Fed and 20% of the Bank of England. The ECB rightly says that its purchases may only be temporary. As a matter of fact, bond purchases by the central bank have to be consistent with the fiscal policies, because the central bank’s interventions can only remedy the symptoms and not the causes of debt. Therefore, the ECB could be justified in intervening only if the causes for the debt, public spending or lack of growth, are faced in a credible manner by the Italian government.

Resolving the political ability to cut debt and implement reforms in Italy is therefore really essential. It is both painful and logical to resort to external authorities to do so, if the country, for its own fault, is not capable of finding another political solution. If Italy fails, the euro fails, so Rome has to take up a bigger responsibility. But it should use such a concession in terms of sovereignty as a negotiating opportunity for a Grand Bargain on a more profound commitment for a European solution by all the euro partners: more supranational vigilance on banks; the swift implementation of more rigorous rules for fiscal discipline and policy coordination, following the new legislation approved by the European Parliament; and a clear support by the ECB of the EFSF role in the defense of the euro area.