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Italy, Gold, and the Euro

Prof. Peter Morici - 11/9/2011

I. Berlusconi Ouster Won’t Avert Italian Default, Euro Collapse


Ousting Silvio Berlusconi won’t make Italy’s fiscal mess any easier—with or without him, its debt is impossible, and Italy is headed for default.

Italy’s problems are fundamentally different than some other troubled countries, such as Greece. Like others its social benefits are too generous but substantially curbing those won’t bring its books into balance. It is simply too late.

Italy’s budget deficit is about 3.6 of GDP—less than half of the U.S. gap, but its total debt, amassed over many years, is 130 percent. That is an amount well above what economists consider manageable even for a country, like the United States, that can print money, and it is even worse for one like Italy without its own currency.

Although the final act of the Berlusconi government was to craft austerity measures that will lower the deficit to less than 2 percent of GDP or about 25 billion euro, it must borrow in 2012 300 billion euro—a massive 19 percent of GDP—in private capital markets to repay maturing debt. Italy is simply not growing fast enough in a Europe crippled by crises in Ireland, Greece, Spain, and Portugal for private investors to take that bet.

If Italy’s nominal GDP were growing at a modest 4 percent and the interest rates it paid on new debt were 5 percent or less, it might manage its way out, however, neither is likely. In recent days, investors have demanded record rates, well above 6 percent, to purchase existing Italian debt, and even at those rates private demand is thin.

The European Central Bank has had to purchase substantial amounts of Italian bonds, and the rate on 10-year Italian debt still pierced 6.7 percent.

Next year, the Eurozone is likely not to grow in real terms, and Italian nominal growth (real growth plus inflation) is unlikely to much exceed 3 percent and is more likely to be nearer to zero. With such low nominal growth, interest rates on Italian debt much below 5 percent would be needed to keep Rome afloat. Even at those rates, the ECB would have to take a lion’s share of Italy’s new debt issues.

The Germans won’t like such purchases, and those are not likely to happen. Even if Berlin went along, the ECB then would be compelled to monetarize significantly more of other European sovereign debt, and the inflation that followed would unravel the myth of stability and unity that justifies the euro.

Italy is too large for Germany, France and the smaller prosperous countries to rescue. Large purchases of Italian debt by France would surely result in the loss of a AAA rating it already doesn’t deserve, push up further French borrowing costs, and put Paris’ finances into a negative feedback cycle. With Europe imploding, even Germany’s finances would not look quite so pristine.

The only sane option Italy really has is to earnestly implement austerity, drop the euro, remark public and private debt in the reestablished lire, and let a falling value for lire in currency markets impose a haircut on private creditors. Under that scenario, the losses investors took from devaluation would be much less than the losses they would endure in the chaos that Italy’s finances could unleash.

II. Italy Next Fail and Gold at $3000?

Europe is approaching the end game—credit markets and other governments know what its leaders won’t admit—the euro is failing. And then gold, more than the dollar, is set to rocket in value as the crisis unfolds.

In addition to looser monetary policy—generous European Central Bank purchases of member country bonds—and austerity—higher taxes and less spending—across most of the EU states, Eurozone governments have a three pronged policy for avoiding a contagion: the European Financial Stability Fund to purchase and insure bonds of troubled governments; IMF supervision of finances for those governments; and direct loans to several and in Greece’s case, a 50 percent haircut on private debt. None of those three policies are working out.

Even with the haircut for private bondholders, Greece will have a debt to GDP ratio of 120 percent a decade from now, if everything goes right. Virtually no independent economist expects things to go that well and most regard the situation as wholly unmanageable.

In 2012, Eurozone growth will be near zero or the continent will fall into a serious recession. With the austerity imposed by the bailout on Athens, the Greek economy will almost certainly contract substantially, and unemployment in Greece, now at 16.5 percent, could easily increase into the low twenties or even double. The crippling effects on tax receipts and demands for social assistance would thrust Greece into a second default, imposing even greater losses on private creditors—private creditors are likely to get only 25 cents on a euro, if that much, when the music stops.

Much like a tropical depression incubating into a terrible hurricane, the Mediterranean contagion is likely already underway. Borrowing rates on Italian debt are nearing what financial analysts and economists view as the tipping point—seven percent. Investors are correctly nervous that Italy too will renege on a portion of its private debt, and fall of the Berlusconi government only makes their uncertainty worse.

A massive bailout from Germany with contributions from France and smaller northern states will ultimately be needed, or Italy would follow Greece into default. Such a bailout is not likely manageable given the resources and political climates in these countries, and the collapse of Italy would mark the end of the euro.

ESFS was established to backstop governments, like Italy, by purchasing some of their debt and offering private investors some insurance on their bonds. Initially, established with 440 billion euro in contributions from Eurozone states, the fund cannot find private investors who will purchase its bonds at affordable interest rates, or backers among sovereign governments with available cash outside Europe.

Simply, private investors and other governments, notably cash rich China and other big exporters, expect Italian and other European sovereign debt to fail. They are concerned the euro will simply implode all together, and then no European government will have both the resources and inclination to stand behind the ESFS’s failing bonds.

With the implosion of Italy, Portugal and Spain would not be far behind, and French debt will come under closer scrutiny. At that point, investors will stampede from the euro denominated debt of most governments, but with rates so low on U.S. Treasuries and too little Japanese and Chinese sovereign debt in open circulation, gold would become the asset of choice.

Moreover, all this could easily unfold as the Super Committee in the U.S. Congress races to a stalemate on an acceptable combination of tax increases and spending cuts. With such dysfunction in Washington, investors would realize that U.S. debt, though still manageable, is racing to an unsustainable level mighty fast, and would start fleeing Treasuries.

At that point, nothing is left but gold. Now trading at $1790, it could zoom right past $2000 to $3000 an ounce.