France and Germany will be very flexible in their response to Italian demands, irrespective of the official rhetoric from Berlin and Paris.
Politicians and financial markets remained surprisingly relaxed after the recent Italian election. Their expectation was that the newly elected parties would act like all Italian parties before and forget about the promises they had made before the election.
And, just in case they would not, that the most important Italian in Europe, ECB president Mario Draghi would somehow make sure everything stayed calm by buying up even more Italian bonds.
However, the new Italian government is blowing the top off the illusionary hope, nurtured by politicians in Brussels and Berlin, to overcome the eurozone crisis by doing more of the same.
Sticking to their program – at the core lower taxes, a basic income for everyone and the abolishment of the past pension reform – will lead to much higher deficits for Italy.
Whatever one thinks of this program, the effort to overcome the eurozone crisis by solving the problem of too much debt with yet more debt has now been unmasked as a fairy tale. The flood of money provided by the ECB in recent years has suppressed the symptoms, but not removed the causes.
It is well known what should have been done
Like it or not, the eurozone needs an orderly process to overcome the burden of too much debt (public and private) and the diverging competitiveness of its members.
The latter requires a restructuring of the membership, which either means that Germany and some other northern countries exit or some of the less competitive countries in the south leave.
But before such a restructuring can take place, the real debt burden has to be reduced. There are not many options. The best way would be an orderly debt restructuring, undertaken in a joint effort by debtor and creditor countries.
In this case, the debt overhang of the public and private sector in the eurozone – estimated in the range of three trillion euros – would be pooled and paid back over a long period of time.
Both creditors and debtors would contribute and the ECB could support this process by buying up part of the debt. The concept has been well-known for nearly ten years.
But this option requires political leaders to admit to the public that the euro was a political project that lacked a proper economic foundation (which is what caused big losses for all countries involved).
Germany played for time
Mrs. Merkel did not show the leadership. She preferred to play for time, banking on the ECB and hoping for a miracle to occur. It did not happen. To this day, there is a persistent denial of the unwelcome reality that the euro is not in Germany’s best interest.
Rather, it is a subsidy for our export-oriented industrieswhich we finance ourselves by giving credit to our international customers, even though most of the latter will never be in a position to pay this credit back. This scheme is about to backfire now.
As much as German leaders will want to deny it, Italy’s new government is correct in insisting on the notion that austerity policies do not fix the problem of over-indebtedness, but rather make it worse. They also do not address the issue of diverging competitiveness.
The policy of Germany with regard to the euro crisis of the past 10 years can only be described as a total failure, amplifying the costs for both: The debtor countries and the main creditor country, Germany.
Had Mrs. Merkel opted for an orderly debt restructuring, she would today be seen as the leader who rescued Europe. Because she did not do so, she will go down in history as the politician who has brought the European project to the brink of collapse by blocking a constructive solution to the eurozone crisis, as well as by unilaterally shifting to a policy of open borders.
Germany can be blackmailed
If Mrs. Merkel wants to keep the illusion of the euro as beneficial for Germany and her image as successful manager of the eurozone, she has to do “whatever it costs” to prevent Italy from leaving the euro.
This will be difficult, as over time more and more power has shifted to the debtors within the eurozone. Underneath the calm created by the ECB, we could see a flight of capital from the southern states into other countries, notably Germany.
The most visible sign of this capital flight, which was encouraged and supported by the ECB’s bond buying program are the so-called Target 2 receivables of the German Bundesbank.
They have exploded to close to 1 trillion euros, which is equal to more than 12,000 euros on a per capita basis in credit given by Germany interest free, without amortization and without any collateral. Given the events in Italy, it is fair to expect a significant jump in this number in the coming month.
Italy is the main debtor under the scheme, with nearly 450 billion euros. In theory, any country leaving the euro would have to settle its Target 2 liabilities first. In practice, it is clear that Italy would never be able to do so. Bankrupt means bankrupt.
A parallel currency
This puts Italy in a very strong position. The new Italian government knows this and acts accordingly. It has taken on the key lesson from the failure of Greece’s Syriza government. You cannot just threaten an exit from the euro, you actually need to prepare for it. Hence Italy’s preparations for a parallel currency.
The so-called Mini-BoTs (non-interest bearing Treasury bills) would be secured by tax revenues, are denominated in euros, but printed only in Italy and are a parallel currency. (BoT is the Italian abbreviation for treasury bill and mini reflects the small denomination).
Once you have a parallel currency in place, it just takes one decree to switch to a new currency for the whole country. Even without doing this, it is conceivable just over time that the Mini-BoTs would become the currency used in day-to-day life in Italy.
This poses a significant political threat to the euro as it would demonstrate that the common currency is by no means “irreversible,” as claimed by its defenders among the politicians.
Indeed, markets would expect other countries to follow — and rightly so. Given those ominous prospects, France and Germany will be very flexible in their response to Italian demands, irrespective of the official rhetoric from Berlin and Paris.
Cancel the debt held by the ECB
This is where another idea of the new Italian government might come into play. A first version of the coalition agreement asked for a partial debt cancellation by the ECB.
This idea is not as crazy as it sounds. For some years, there has been a serious discussion going on among economists as to whether a debt cancellation by the central banks could be a solution to the over-indebted world economy.
Adair Turner, former head of the Financial Services Authority in the UK, is the most prominent supporter. In his view, central banks should just buy up significant parts of the outstanding debt and then simply cancel it. As central banks never can become insolvent – they just “print” the money – this would be a miraculous way to get rid of the debt.
Critics of such a maneuver fear a loss of trust in the value of money and the emergence of Weimar-type inflation. However, the scheme’s supporters argue that, as long it is a one-off measure, there should be no negative impact.
Japan may provide the relevant policy example that such an approach could work. The Bank of Japan is currently holding more than 50% of Japan’s debt and will soon own above 70%. Observers expect a debt cancellation in the coming years.
Implementing such an approach in Europe is more difficult, as it involves several countries and implies a redistribution of wealth between countries. Naturally, countries with higher debt levels will benefit the most.
Although it seems unimaginable to many outside observers of the German political and economic scene, it is fair to assume that German politicians would ultimately be prepared to accept such a solution, in spite of all their public statements.
Like it or not, the new Italian government is in a much stronger position than many observers and politicians in Germany are willing to accept. Already back in 2012, a Bank of America analysis showed that from the vantage point of game theory the most probable result is a successful blackmailing of Germany by Italy, followed by an exit of Italy from the euro.
However this unfolds, the end game seems very near. Irrespective of how this plays out, there can be no doubt that the illusion of having resolved the eurozone crisis is vanishing rapidly.