Italy
Next up, Italy. There are two things you need to know about Italy. The first is the scale of its debts. It owes $2.6 trillion, or well over three times what Lehman owed at the time of its collapse. (And where Lehman owned over half a trillion dollars’ worth of saleable financial assets, the assets belonging to the state of Italy are primarily things like wonderful beaches, Roman ruins, and Renaissance art. Nice things to have, but not so easy to sell.) On some measures, indeed, Italian government bonds form the world’s third largest bond market, after the US and Japan. The market is so huge and so liquid (for the time being) that few bond investors of any scale can afford to be out of it. That’s helpful, assuming that there are no concerns about creditworthiness. If there are such concerns—and there are—financial contagion on a massive scale is pretty much guaranteed.8
The second thing you need to know about Italy is the state of its politics. Indeed, this book went off to be typeset containing a couple of paragraphs about Silvio Berlusconi. About his clowning, his trials, his media empire, his sometimes bizarre political views. I took the view—and still do—that no country could be viewed as creditworthy with such a clown at the helm.
Unsurprisingly, however, events caught up with me. In November 2011, Berlusconi was tipped unceremoniously out of office. He was displaced not by his voters, but by the bond markets working, on this occasion, in collaboration with the horrified duo of Angela Merkel and Nicolas Sarkozy. His government has been replaced by a technocratic government containing not a single elected official. I’ll talk more in a later chapter about the democratic failures of the current crisis, not only in Italy but across the globe. For now, though, consider this. The people of Italy have not voted in favour of austerity or economic reform. No leading politician has cogently delineated the problem or set out a game plan for reform. No election campaign has pitted rival ideas against each other. The electorate has not been forced to look at the current reality and endorse a particular solution.
The result is that the current Italian government lacks a popular mandate. The people of Italy can hardly be unaware that the bond market is raging at the door and that their position within the eurozone has never looked more perilous – but an awareness of disaster is far from being the same thing as a plan, broadly shared by the electorate, of what to do about it. Indeed, one of Berlusconi’s most toxic legacies has been the way he chose to infantilise politics, the way he made it seem less important than the next bunga bunga party.
All this matters because countries need leadership in times of danger, and the danger facing Italy is now acute. By mid November 2011, interest rates on Italian ten-year bonds were pushing towards 8%, nudged upwards by worries of an economic slowdown and insufficient government zeal in tackling the country’s excessive debt, and exacerbated by the uncertainties of the eurozone’s stumbling response to crisis.9 These are times of almost breathless risk for the world economy. To understand those risks, you need, once again, to see things through the eyes of the bond market.
Italy has a decaying economy. Some of its best industries are located in segments, notably shoes and clothing, where production is shifting remorselessly to lower-wage economies. Italian firms will do fine. They’ll simply offshore their production to the degree required—indeed, typically alert and nimble, they are already doing so. The outlook for the Italian economy is far less rosy, however. The south of the country is backward, corrupt, and still prey to organized crime. The north of the country has some fantastic enterprises, but is still hampered by a creaky state sector, a lack of innovation, and too many uncompetitive industries. Between 2000 and 2010 the Italian economy managed growth of a puny 0.25% a year, or a little more than 2.5% in a decade. The German economy is perfectly capable of generating that much growth in the space of a few strong months.10
Dazzling economic growth is not, therefore, remotely probable either now or in the near future. (The one gift Berlusconi did unquestionably bring his country was a period of real political stability. It is unforgivable how little use the country made of that.) So the only plausible way out of Italy’s growing budgetary hole is for the government to slash its spending. In the months before Berlusconi’s departure, Giulio Tremonti, the Italian finance minister and a highly capable individual, understood the imperative and prepared a budget packed with deficit-slashing measures amounting to some €40 billion ($55 billion). Those measures included many which would hurt the pockets of the least well off: increased health charges, reduced cost-of-living increases in some state pensions, a probable increase in sales taxes, reductions in local authority budgets, and so on. These things hurt. They hurt ordinary people in real ways and the hurt is lasting, not temporary.
So imagine the shock when detailed analysis of the budget revealed that Berlusconi had smuggled into it provisions that stood to save his media company, Fininvest, some €750 million by postponing damages it was due to pay. It was alleged—I don’t know with what truth—that neither Mr Tremonti nor Berlusconi’s political allies had been told of this clause, but in any case Berlusconi withdrew it amid the inevitable uproar. The episode is instructive. Even under extreme economic pressure, the Italian government is so dysfunctional it is capable of behavior that would shame many an African kleptocrat. What’s more, the bulk of the budget’s cost-cutting measures were reserved for 2012, hinting that there might well be an intervening election—in which case, there is no guarantee that a new government would feel obliged to honor the pledges of its predecessor. It’s true that this unseemly episode took place when Italy was still being led by Berlusconi, but he isn’t the point. It’s the political system which allowed him to get to the top in the first place. That system remains entirely unchanged – and, indeed, for that reason the arguments of this section (and this chapter) remain valid no matter what further changes of leadership there may be.11
It is against this background of limp growth and budgetary uncertainty that Italian bondholders are obliged to form their judgments—judgments which leave the country teetering on the edge of a precipice. If bond yields stay at their current levels of close to 7%, the mathematics of indebtedness (the same kind of logic we looked at in relation to Portugal) would seem to imply that the government’s debt has become insupportable. That the country has become insolvent. If bond yields fall back below 5% and stay there, the government’s position is arduous but probably tenable.
If Italy were to find its Margaret Thatcher, and if that leader were to have a strong and united parliament at his or her back, and if the country at large were broadly supportive of strong medicine and harsh measures, the country would be fine. It would be not merely one of the pleasantest countries in the world to visit or live in, it would also become a financial and economic success, a safe haven. But it has no Thatcher. It has no unity. It lacks any sense of common purpose.
The country could still go either way. It could survive and thrive or it could go the way of Greece. I hope it flourishes but I’m not hopeful. Italy needed a lion, its people elected a clown. The new government may or may not have lionhearts in its number—but the Italian people still have yet to speak.
Spain and France
All this is getting very gloomy, so I’ll be as brief as I can. In Spain and France, the outlook is not as dire as in Italy. Yes, growth is far too weak. Yes, debt is too high. Yes, budget deficits are yawning. But still, it’s better to have debt at 65% or 90% of GDP than to have it at Italy’s crazy 120%. In both Spain and France, politicians may have been too slow to get a grip on their problems, but their leaders are no Berlusconis.
Because Spanish growth is lackluster and (aside from a crazy property boom) has been for some time, the outlook for Spanish bonds is worse than for French. Though the problems in Spain are less severe than they are in Portugal, the difficulties are clearly analogous.
France, by contrast, has far more strong international companies than does Spain. It has a hugely impre
ssive ten in the global Fortune 100, including Total, AXA, Carrefour, and Peugeot. Spain has only three.11213 France is also more politically influential. It has long been seen as one of the twin engines of Europe, alongside Germany.
In part because of its size and importance, bond markets have largely chosen to see France as a safe haven, Spain as imperiled. In the summer of 2008, French bond yields came close to 5%, but have fallen a long way back since. In the summer of 2011, Spanish bond yields spiked at well over 6%, a level close to which one has to start doubting the long-term solvency of the Spanish government. In brief, therefore, the two countries share problems similar to those of their neighbors, but to a lesser degree. Bond markets judge that Spain is in greater danger than France—a fair assessment—but as of now (early November 2011) the markets are betting on a generally positive outcome, not a disaster.
And perhaps that’s correct. Perhaps that is, indeed, where the balance of probabilities lies. The trouble is that, as we know, markets aren’t ultimately guided by a balance of probabilities. They’re guided by reality, and both France and Spain are sailing through seas that are heavily mined. The mines in question are partly political, partly financial.
In France, the political danger is simply that a government comes into power which lacks either the will or the ability to do what needs to be done. French socialist contenders for office seem to have difficulty in recognizing elementary realities. Arnaud Montebourg thinks banks should be forbidden from speculating with clients’ deposits. (So they couldn’t make any loans, presumably.) He wants to abolish ratings agencies. (Because they tell the truth, I guess.) And he berates financial markets for wanting to turn France ‘into their poodle.’ (Actually, Arnaud, the bond markets don’t want a dog, they want to know they’re going to get their money back. You know: the almost $2.5 trillion that France borrowed.) Meantime Martine Aubry wants to fix the looming pensions crisis by bringing the pensionable age down from sixty-two to sixty. François Hollande wants to create 300,000 public sector jobs. And French voters appear to be partial to this nonsense. Almost three-fifths of the population want higher trade barriers to be erected unilaterally. The same number think trade with India and China has been bad for the country.14 Nicolas Sarkozy, supposedly a politician of the center-right, came to power promising sweeping structural reform and has delivered almost nothing. His popularity at home is bumping along the seafloor, yet from a bond market perspective he still looks like the least bad of the possible leaders.15
In Spain, the political dangers come from the street. In May 2011, tens of thousands of Spaniards, mostly young ones, took over central squares in sixty cities across the country. Time magazine’s story about the protests went under the headline ‘Has the revolution come to Spain?’ If it has, I’ve a lot of sympathy for the protesters. Appalling, discriminatory, and stupid labor laws have allowed unemployment to rise to 21.3% and youth unemployment to an outrageous 46.2%. Those kids who do have jobs tend to have poorly paid and insecure ones. The politicians seem to care more about taking kickbacks (over 100 candidates in recent local elections were under judicial investigation) than about solving these problems.16 Holders of government bonds, meanwhile, care only about one boring thing—getting their money back—and political turbulence on the current scale is hardly reassuring.
So much for the political mines. The financial mines are, if anything, more dangerous. The French government has debt of around 90% of GDP. The country also boasts a number of very large banks. BNP Paribas, Crédit Agricole, Société Générale, and Banque Populaire / Caisse d’Epargne are all members of the global Fortune 100. Yet no one truly knows if these banks are solvent. French bank shares are down by 33% since the start of 2011. Spreads on credit default swaps—a measure indicating the probability of default—have increased to levels last seen in the fall of 2008.17 And we know what happened then.
*
In a hard-hitting recent speech, Christine Lagarde, the head of the IMF, estimated that unrecognized losses on European bank balance sheets amounted to more than €200 billion and called for urgent, compulsory recapitalization of the banks.18 From an international policymaker, this was bruisingly direct talk—but pessimists in the private sector make her look like the sunniest of optimists. A note released by Goldman Sachs in mid-August 2011 argued that European banks might need as much as €1 trillion in new capital.19 And forgive me for stating the obvious, but a trillion euros is a lot of money. Cast your eye back to table 16.1 and its summary of the financial position of Europe’s principal economies. Neither Italy or Spain can risk taking on a penny’s worth of new debt. France and Germany might be able to find a hundred billion or two between them, but neither country can afford to be profligate. Quite simply, there is not a trillion euros’ worth of available public capital in Europe. If Europe’s banks need a bailout on that scale, it’s not coming from the taxpayers.
It’s not clear, however, that private investors are likely to open their wallets up either—nor that they should do so in order to finance irresponsible lending practices and weak managements. Through the summer of 2011, equity prices in Europe lost one-third of their value. Bank stocks sharply underperformed the overall index. Those drab facts hardly suggest that investors are falling over themselves to plug any funding deficits. Indeed, the real truth is worse, because, as share prices plunge, any capital-raising has to be done at increasingly depressed prices. Since capital-raising under these circumstances would heavily dilute the ownership position of existing shareholders, those shareholders—the people who ultimately call the shots—will be heavily resistant to taking the only course of action liable to avert Armageddon. In short, the banks may need a huge amount of money, and no one has any idea where it might come from. Bank chiefs and financial regulators are currently working with a strategy that can be summarized as eyes shut and fingers crossed.
These things haven’t exactly escaped the attention of the financial markets. All through 2011 there’s been a growing sense of jitteriness—mirroring to an uncanny degree the anxiety felt in the months between the collapse of Bear Stearns and the Lehman bankruptcy. That nervousness has manifested itself in an acute risk-aversion. American money market funds are pulling their cash out of Europe. Interbank loans have become ever shorter in duration, meaning that ever larger volumes of money have to roll over every week. French banks, indeed, have effectively lost their access to this market. And these things matter. As so often in this book, I find myself making statements that sound boringly technical. European bank funding is becoming more short-term: I mean, do you really care? Has a statement like that ever bothered you in the past? I’m guessing not. But these things are likely to affect you personally, and massively. Your job, your pension, your savings, your government may come to depend on these things.
The disaster scenario is this. A big bank—let’s say a mythical French one, the Banque des Grandes Baguettes (BGB)—announces unexpectedly large losses on its sovereign loan portfolio. It has become highly reliant on short-term funding, but money market funds and the interbank market now cut it off completely. BGB is now totally reliant on funding from the European Central Bank, and the ECB in turn comes under acute pressure to force a restructuring or bankruptcy filing. Maybe the ECB caves into that pressure, maybe it doesn’t, but either way the market is in a panic. In Italy, the Banco Bunga Bunga announces that it too has lost the ability to fund itself. In Spain, the Caja Sangria is in trouble. In Germany, it’s the Weisswurstundpilsner Landesbank.
As these events unfold, the government bond markets will slide into a state of panic. The huge Italian bond market, for example, is likely to freeze almost completely. The market for Italian credit default swaps would start to resemble the current market for Greek CDSs. No lender would trust that any other lender was solvent, so the interbank market would be more or less extinguished.
This is the point of catastrophe. The financial system is, very
largely, constructed like those circles of people each of whom is sitting on the lap of the person behind them. If everyone is stably seated, there’s no problem in maintaining the circle. But as soon as you start pulling out individuals, the circle collapses. When Bear Stearns and Lehman disappeared, Wall Street lost its two weakest players, but the consequence was that even the strongest ones were on life support. Goldman Sachs, remember, for all its boasting that it required no government bailout, nevertheless found itself accepting $69 billion worth of funds from the Federal Reserve.20 That’s not quite the same thing as avoiding a bailout, if you ask me.
And the situation today is precarious in the extreme. Don’t take my word for it. Ask Josef Ackermann, the CEO of Deutsche Bank, the world’s second biggest bank by assets (and, by the way, a well-managed one, though with much more leverage than I personally would like21). At a meeting of bankers on September 5, 2011, he said: ‘It’s stating the obvious that many European banks would not survive having to revalue sovereign debt held on the banking book at market levels.’22 Notice what he’s saying. Remember that the market price for a government bond is the fair price for it. If the market priced a bond too high, people would sell it and take their profits; if the market priced a bond too low, people would buy it, on the expectation of gains. So the market price for bonds—just like the market price for anything else—is the fair price. It’s the only realistic one you can use. But European banks aren’t using that price, because they can’t. Instead, they value these loans at a fantasy price when they draw up their accounts, because if they didn’t they’d be bankrupt.
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