12 July, 2011

First A Greece Fire, Now Rome Is Burning

Actually, the bad news in Italy has been going on for about as long as Greece, and possibly longer. It’s just been quiet lately, comparatively. But, in case you haven’t been paying attention the last few days, things have heated up again. This is even worse news for the U.S. and the world than what’s been coming out of Greece, simply because the Italian economy is far larger.

But the contagion that started in the euro zone’s smaller countries is suddenly moving to some of its largest. As Greece teeters on the brink of a default, the game has changed: Investors are taking aim at any country suffering from a combination of high debt, slow growth and political dysfunction — and Italy has it all, in spades.

Sound familiar?

In recent days, Italy has become Europe’s next weak link after Greece, Ireland, Portugal and Spain, harmed in particular by a power struggle between Prime Minister Silvio Berlusconi and his finance minister, Giulio Tremonti. The dispute threatens to turn the euro zone’s third-largest economy, after Germany and France, into one of its biggest liabilities.


For Italy, the biggest worry right now is that its fate may rest as much in Athens, Brussels and Berlin as it does in Rome. Only a week ago, it looked as if Greece might be turning a corner on its problems, after the government managed to push through an austerity package and French and German banks worked on ways to help Greece avoid default.

But the plan by banks fell apart over the weekend, and policy makers are at an impasse on how to require contributions from private creditors as part of a second Greek bailout.

Italy’s biggest worry is everyone’s biggest worry, including the United States. Forget dominos, the world economy is currently based upon a huge house of cards.  Look at the pic below. Click on it for a full-size view.

When Greece falls (yes, I said “when”, not “if”), the effects will be felt all over Europe. It’s hard to see how some of the teetering economies there will be able to survive. Spain in particular is very weak, perhaps the weakest card on the table. One of the many problems is that everyone has been financing everyone else’s debt, like paying off one credit card with another. Eventually that stops working and the debt comes due. That time is now for Europe and the United States.

Greece is back in the news because, despite their reluctant acceptance of the European austerity plan, it wasn’t good enough for the credit agencies.

However, because the proposals left bondholders nursing losses, S&P yesterday ruled that they would amount to a default on the debt.

This sets up Germany and France for a clash with the ECB. The proposals are contingent on Greece not defaulting on its debt, because the central bank has said it will not accept defaulted bonds as collateral for loans. But any deal that satisfies German demands that bondholders take a share of the losses is doomed to failure since, based on the S&P ruling, it would trigger a default.

In fact, Greece defaulting on at least part of their debt seems unavoidable at this point. That has always been the most likely scenario, as even the austerity measures were just kicking the can down the road a few months. S&P’s statement that they won’t accept the current plan just moves the can back up the road. In other words, to now.

The outlines of the new rescue emerging this morning pitted Germany against the European Central Bank, with elements of the deal designed to accommodate both camps. Bailout fund buybacks are supported by the ECB, while private creditor losses are a German condition.

Accepting that a Greek default was now impossible to avoid, EU governments are hoping it will be brief and "selective", not triggering a "credit event" on the financial markets that could wreak havoc on the credit default swap markets, also in the US, and unleash contagion.

As the picture above shows, there are firestorms now all over Europe. It’s hard to say which one is the “lynchpin” as they’re all interdependent. Perhaps a selective default in Greece is survivable. I’m not sure. Almost certainly, an Italian collapse is not. I believe that they’re going to need a huge amount of external funding to avoid collapse, from China, the United States, Russia, or Japan. The problem is that all of these countries have problems of their own, and are unlikely to invest hundreds of billions of dollars in what is clearly a bad risk, even if they had the funds to do it.

I’ve been saying for a while now that the real problem that U.S. faces is not the debt ceiling, but when we reach the point where no one will buy our debt. Clearly, no one in Europe is going to be buying any in significant quantities in the foreseeable future. That’s got me thinking about the debt ceiling talks again. At first I thought that the idea of not raising our debt ceiling was crazy. Then I began to think it wasn’t quite so crazy after all. Now I’m starting to wonder if that might be the only solution. We have to have our financial house in order in the event of a European collapse, to avoid one here. Regardless, if that happens, it’s going to wreak havoc on our economy. But, if we have our own finances in order by then, and we’re not spending like there’s no tomorrow, then we can probably pull through.


If we have our own finances in order.

Yeah, I know. I still believe in Santa Claus too.

Anyway, I’m still not quite ready to jump on the “don’t raise the debt ceiling” bandwagon. But I am checking to make sure there’s a spot aboard for me. I have a feeling it may get crowded there over the next couple weeks.

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