All Roads Lead to Crisis

Giulio Tremonti is obviously a man who thinks highly of himself. This weekend, Italy's embattled minister of finance confided to the Corriere de la Sera newspaper that a political attack which resulted in his resignation "could bring down the euro."

The interview came after a difficult few days for Tremonti. In comments published Friday by La Repubblica, a center-left newspaper, his boss, Prime Minister Silvio Berlusconi, criticized Tremonti publicly and fiercely for his handling a major four-year austerity package that is tortuously making its way to the statute book (Berlusconi later claimed that the paper took "a friendly conversation and turned it into a formal interview.") On Thursday, magistrates called for the arrest on charges of corruption of a parliamentarian who was a close advisor to Tremonti and who was providing him with free, luxury accommodations in Milan.

In truth, Berlusconi's main contribution to Tremonti's 40 billion euro austerity package -- aimed at convincing investors that the country will not go the way of Greece, Ireland and Portugal -- has been to undermine it. He has pushed for new income tax cuts, to be compensated for by consumption tax raises and new duties that will overwhelmingly hurt the middle- and lower-earners. Berlusconi also attempted to surreptitiously insert in the emergency budget a clause protecting him from having to pay a huge fine related to his Fininvest media conglomerate, only cutting it after a storm of outrage. Hence it is no surprise that markets view the 64-year Tremonti, now in his fourth term as finance minister, with much greater trust than his perpetually clownish political master.

The wider significance of these developments, to which Tremonti alluded in his comments to Corriere de la Sera, was already evident late last week. Spreads between German and Italian bonds reached their highest levels since the birth of the euro. Italian 10-year bond yields climbed to a 9-year high, and Spanish yields also approached euro-era peaks. On Monday, spreads for both countries kept on climbing. In a darkening European environment, with Portugal's debt downgraded to junk status by Moody's last Wednesday and negotiations stalling on Greece's new loan package, news of friction between Italy's prime minister and the minister in charge of its troubled public finances was bound to agitate investors.

The markets' dwindling confidence in Italy and Spain, the two giants of southern Europe, may be the prelude to an absolute nightmare scenario for the leaders of the Eurozone. Italy is the European Union's fourth largest economy; Spain its fifth largest. The EFSF, the temporary fund set up by Eurozone countries to bail out troubled European economies , has at best 250 billion euros in available funds, a sum that it has been trying to raise to 440 billion euros. This, along with the contributions from the IMF, has been more than enough to cover Portugal and Ireland, and will suffice for a second bailout of Greece as well (the first one was ad hoc, as the EFSF had not yet come into existence).

But Italy and Spain are a different order of magnitude. Italy's public debt was 118% of GDP in 2010, second only to Greece as a percentage. The absolute level of its debt was 1.6 trillion euros - almost five times that of Greece. Spain's debt-to-GDP ratio is far healthier - 60 percent in 2010 - but that still amounts to over 600 billion euros. Madrid is set to issue 192 billion euros of government debt in 2011 alone. It is clear that existing bailout mechanisms cannot save either country. Not only that, but, were they to require a bailout themselves, both Italy and Spain would no longer contribute to the EFSF, probably leaving it short of funds to deal even with the three countries already in a state of suspended bankruptcy.

Fears that the two countries will be overtaken by the avalanche of Europe's debt crisis are compounded by their less than stellar growth prospects. As the Economist pointed out in a recent special report, only Zimbabwe and Haiti had worse growth statistics than Italy in the decade to 2010. Sound fiscal management and adequate bank supervision saved Italy from some of the worst consequences of the global financial crisis. But Berlusconi has done little to usher in the kinds of structural reforms that will reverse its long slide in competitiveness, and the austerity of the years ahead will deprive
the economy of much needed oxygen.

As for Spain, its pre-crisis growth rates were too dependent on a booming real estate sector, whose collapse has led to a catastrophic rise in unemployment - it now stands at 21.3 percent - and to serious questions about the viability of some of its banks. The main worry here is that the public will have little patience with further waves of austerity to mollify nervous investors (it was in Spain, after all, that the protest Indignant movement was born last May).

But the bigger worry that is roiling the markets, and putting Spain and Italy in jeopardy, is that Europe's leaders do not have it in them to make the historic decisions necessary to save the euro. A high priority is the issue of common euro-bonds, guaranteed by the Eurozone countries that retain triple-A credit ratings. Germany had in the past rejected these bonds but seems now more open to discussing them. The creation of a successful, liquid market in euro-bonds will allow Greece, Portugal and Ireland to refinance their debt at low interest rates (under 4 percent, when, for example the market is now offering Greece rates over 17 percent for 10-year bonds). This will give them vital breathing room to reform and grow their way out of the fiscal hole they are in.

The idea of a euro-bond was introduced into the European conversation in an article last December, co-written by Tremonti and Eurogroup president Jean-Claude Juncker. It is the delay in the adoption of this idea at a European level, largely due to German opposition, more than the dilution of Tremonti's austerity measures in Italy, which really threatens to bring down the euro.

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