When in Rome, Run Like Hell! That might be prudent advice to politicians, investors, and Italian citizens these days, as the financial crisis threatens to overtake the world's eight largest economy.
I imagine that you've gotten pretty tired of hearing about the "Greek crisis." Well, you may want to prepare yourself for a much bigger Italian tragedy that could unfold in the coming months. This isn't just a matter of concern for central bankers, Euro-crats, and hedge fund managers. American progressives should be very worried about the impact of the Euro crisis on American jobs, the economic recovery, and President Obama's re-election prospects.
To put the Italian foreign debt of 2 trillion Euros ($2.74 trillion) in perspective, Greek foreign debt is a mere 400 billion Euros ($550 billion). Now, compare these figures to the pre-crisis (July '07) market capitalizations of some of the firms most involved in the 2008-2009 financial collapse: Citigroup - $250 billion, AIG - $181 billion, Lehman Bros - $39 billion, Bear Stearns - $22 billion. The point? These so-called "too big to fail" institutions were far smaller in value and reach than any of the countries in question -- especially Italy.
[Financial folk would correctly point out that I'm comparing apples (sovereign debt) to oranges (bank equity values). Indeed, banks' debt was much larger than their equity values. But I'm going to spare you a technical attempt at trying to put banks' debt and sovereign debt on a comparable basis. The simple point here is that there is a stark difference in scale between banks and sovereigns and, therefore, the collateral damage that their failures might cause.]
These days, no number is more important than the interest rate on a country's long-term debt. Why? Because it indicates how risky the market generally believes a country's debt to be. (The higher the expected risk, the higher the required rate.) And markets often do a pretty good job of assessing risk (far better, at least, than do ratings agencies). Indeed, even if the market's "view" is wrong, markets have a tendency to develop self-fulfilling prophesies. Thus, a "wrong" view can become "right." (More on that later.)
The interest rate on 10-year Italian bonds is saying a very scary thing: Italy may be on the brink of a financial crisis of staggering proportions.
[These numbers can also be misleading. The fact that the U.S. has such low rates is not an indication that everything is rosy for us. Rates say as much about a country's relative health as they do about its absolute health: the U.S. is not in great shape, but it is safer than, say, Italy or France right now.]
Is Italy the next Greece? Well, as many economists have pointed out, Italy is in an entirely different class in terms of economic diversity, size, and clout. In fact, putting aside the interest that it pays on its debt, Italy is actually running a budget surplus (called a "primary budget surplus"). Greece is not. Greece is like a manic shopper who, having run up an enormous credit card bill, continues to charge more to his card than he earns. By contrast, while Italy overspent in the past, its spending and earnings are currently matched pretty well. It has recovered from its drunken-sailor spendthrift ways. Unfortunately, all of that past spending has led to a huge foreign debt; it has already accumulated to approximately 110% of its GDP. That is, its debt balance is worth more than the full value of a year's worth of everything produced by every person and company in Italy. If Italy were a person, his credit card balance would be greater than a year's worth of his salary. Yikes! Time to call 1-800-BANKRUPTCY.
As investors have become more nervous about Italian debt, the interest that they have demanded has shot up, from 4% a year ago to close to 7% today. That may not sound like a big difference. But remember that the Italian economy has been stalled out for years. Going back to our personal analogy, our debt-laden Italian has found himself with a credit card balance greater than a year's worth of salary, rapidly increasing interest payments, and a dead-end job with no raises in sight. Without meaningful economic growth, Italy will find itself forced into a "debt trap" from which there may be no escape.
Italy happens to be fairly well funded for at least several years. So it doesn't have to go back to the market for a great deal of new debt at these much higher rates immediately.
The problem is that debt crises are much psychological as they are financial. If investors decide that Italy's debt burden is fatal, they'll run for the door well before the country has to renew its debt. And we'll effectively have a "bank run" on an entire country.
At this point, there are few indications that investors are about to flee en masse. But the mere fact that we keep talking about the possibility spawns further fear. In other words, it can become self-fulfilling.
The largest sovereign default in history was that of Argentina in 2001, when it announced that it would not pay all of the interest and principal on its $81 billion of debt. Needless to say, it is very unlikely that Italy would simply refuse to pay its debts, period. Even Greece has not gone quite as far as a full default yet. But the fact that Italian debt is close to 35x larger than Argentina's was is reason enough to be nervous. A run on Italian debt would drag down many German and French banks and, consequently, induce another financial crisis here in the U.S. (Losses on Italian debt were partially responsible for this month's collapse of U.S. broker MF Global.)
This is heavy stuff. Let's hope that Italy's new Prime Minister, Mario Monti, can better persuade investors, the European Union, and his own citizens that he understands the seriousness of this situation. It's hard to imagine that he'd do a worse job than former Prime Minister, media tycoon, and clown-in-chief Silvio Berlusconi did.
Currently majoring in Business & Public Policy at The Wharton School's MBA program, Andrew Solomon is one of the founding Board members of ACT NOW. He oscillates between voicing views that earn him censure and biting his tongue for the good of all (including himself). He summarizes his political philosophy as "progressive ends, pragmatic means." You can reach him at solomon [at] actnowny.org. More by Andrew at http://www.actnowny.org/...