Why I am Going to Worry about Italy on my Summer Vacation

I am about to take a two week vacation (though will update the blog). I had some time off earlier in the summer, but it was dominated by the concerns of a father of a Little League baseball pitcher. Rather than worrying about mechanics and scoring, I will be contemplating the tragedy that is Europe and I think Italy is the keystone.

Italy is the largest piece of counter-evidence of the German-ECB narrative that the lack of fiscal discipline is at the center of the crisis. Italy's actual budget deficit in 2010 was 4.6% of GDP. The deficit for the euro zone as a whole was 6%. The Dutch reported a 5.4% deficit and France showed a 7% shortfall. Spain's deficit was twice Italy's.

Italy did have a deficit problem, but that was years ago. Those policy errors are part of the reason that Italy has accumulated debt that is approaching 120% of GDP.

The other part of the reason is that Italian growth has ceased. Its average growth rate over the past decade is less than 0.25%. Euro zone growth has averaged 1.1% over the same period. Moreover, Italy has experienced a steady increase in its labor force as a result of 3 mln immigrants (estimates suggest about a third entered the work force). On a per capita basis, Italy has become poorer.

The past deficit plus slow growth has created the mountain of debt. With the wolf knocking on the door and 10-year bond yields pushing above 6% last month, the Italian government responded with new austerity measures in early August.

This did not prove sufficient and the ECB insisted on yet another round of austerity as the condition under which it would buy Italian bonds in the secondary market, over the objections of four ECB members, including Axel Weber's successor at the Bundesbank.

The ECB's bond buying is not sustainable. There appear to be some potential technical problems with neutralizing/sterilizing increasing amounts, but more importantly, the ECB is buying the bonds reluctantly and as a stop gap measure until the reforms agreed July 21 of the EFSF are approved. That is proving to be more of a problem than many expected as the dispute over Greek collateral threatens to postpone if not outright jeopardize that agreement.

There may also be a political backlash against the ECB, which could take many forms, including wider spread criticism of the deterioration of its larger balance sheet. The German Constitutional Court is expected to make a ruling in the first part of September.

Even more importantly, is scale. Already the ECB buying of Italian bond seems to have reached a point of diminishing returns. Italian 10-year bond yield rose around 13 bp this past week and at 5.06% is at a two week high. What happens when it steps away?

Italy has around $250 bln of bond maturing in H2 11 and another $352 bln maturing next year. The ECB has holds an estimated 20% of Greek, Portugal and Irish outstanding bonds. It does not have the political will to do the same for Italy and Spain and even the new EFSF is unlikely to be large enough. The rules and conditions for the EFSF's precautionary lines of credit are not clear yet and Italy probably can't count on it any time soon.

The fact of the matter is that in every year since 1991, Italy has reported a cyclically adjusted primary balance surplus. There has been no spike that other countries have experienced in debt levels.

European officials have implicitly and explicitly indicated that reaching austerity targets is more important than reviving growth. That calculus threatens Italy.

Even before this month's two austerity packages, the Italian economy was sputtering. Yes it appears to have eked out a little more growth than Germany's Q2 0.1% performance, but the economy lacks any upside momentum in Q3. The service PMI was below 50 in June and July/ It likely remained below the boom/bust level in August. The manufacturing PMI has averaged about 50 in the June/July period but is likely to have fallen below 50 in August (to be reported Sept 1).

The fact that Italy's 5-year CDS prices remain elevated (376 now vs 388 on Aug 4 peak) warns that ECB bond buying, fiscal austerity has not convinced private sector investors that the worst is truly past. This offers a poor backdrop from the large maturities that are set to take place.

As goes Italy, so goes EMU.