Official Action and Why Italy is Still at the Vortex

The focus is on next week's ECB meeting and the EU summit. Nearly every one is expecting a 25 bp rate cut and if expectations are wrong, it is more likely that it is because of more aggressive action, like a 50 bp cut, than less. Separately, it will also likely provide long-term refi operations. It currently has a 1 year repo outstanding and next month will offer 13-month money that covers two year end periods. Next week it may offer 2-3 year money. It may also liberalize its collateral rules again.

The EU Summit is the last opportunity of the year, and some observers say the last opportunity period, for action that will begin seriously addressing the crisis. Tomorrow France's Sarkozy is expected to present his proposals tomorrow and Germany's Merkel Friday.

While Germany and French proposals to expedite a fiscal union are important, watch what Italy does. Before the summit, Italy will likely announce a new package of austerity that will take several important steps toward what Merkel and Sarkozy have in mind that are necessary for fiscal union.

Italy's technocrat-led government will likely propose more austerity than envisioned by the Berlusconi government and will make more realistic assumptions on growth, preparing, for example, for a 0.5% contraction, which is what the OECD projects. A wealth tax of sorts also seems likely.

Note that during the run-up to EMU, Italy's economy was stagnant, with a current account deficit, and still managed to reduce its deficit. A 0.6% tax on savings was implemented. A property tax on large holdings (larger than 1 mln euros) or another savings tax is possible. Pension reform and labor market reforms are also likely.

In addition to these austerity measures, fiscal convergence also requires more credible oversight of public finances. One of the things that Merkel and Sarkozy are likely to call for is a independent body to oversee public finances, make budget forecasts and provide a scorecard. The Monti government is likely to do precisely this.

Many pundits talk about the pressure on Germany and ECB to capitulate, but that is only half the story. The other half is that pressure on countries to cede some more fiscal autonomy is also great.

Der Spiegel has quoted the Polish foreign minister, which illustrates how far things have come: I will probably be the first Polish foreign minister in history to say this, but here it is--I fear German power less than I am beginning to fear German inactivity."

The cut in the rates dollar funding can be secured through the Fed's swap lines today is noteworthy. It may address some funding pressure, but the forces on the other side seem stronger still. Downgrades and asset sales and credit line reductions all point to continued funding challenges.

There is also a stigma to accessing those swap lines. Part of the reason they were not used may be partly because of price, but in recent days the cross currency swap appears to have been risen to levels that made the punitive rate from the Fed more competitive.

European banks need to refinance an estimated 800 bln euros next year. More valuable than the cut in the swap rate today would have been follow through on the European promise for an EU-wide bank guarantee scheme like they had in 2008-2009.

Banks, including Spanish, French and Italian banks, have relied more on borrowings from the ECB. Banks have also used liquidity swaps to create billions of euros of assets that can be used as collateral to borrow even more from the ECB. The FSA has identified these liquidity swaps as a transmission mechanism for systemic risk.