After the eurozone’s small peripheral countries,market fear is enveloping Italy and Spain. The yields of their public debt have risen sharply; investors are losing faith in their banks. This is still a phoney war, but if a decisive battle is going to shape the future look of the eurozone it will be fought here.
Both countries’ borrowing costs have moved nearer 7 per cent – which markets have latched on to as the yield at which a state’s debt dynamics become unsustainable. This is magical thinking. Which borrowing costs can be serviced sustainably depends on many other things: the size of the debt burden, growth and inflation rates, the government’s ability to run primary surpluses, and the maturity profile of the outstanding debt.
For both Spain and Italy, those fundamentals need not scare markets into a panic. Spain has low debt and a sharply falling deficit. Italy, although its debt level is the eurozone’s second highest, runs a primary surplus, and its debt matures slowly. Both countries can, if they must, afford to pay yields well in excess of 7 per cent for an extended period.
That it is feasible does not make it desirable. Italy and Spain cannot allow themselves any complacency about high yields. That would even be true were it just a matter of saving money on borrowing costs. But the greater danger is that high yields entrench a perception in the market that one or both countries have gone off track and will struggle ever more to refinance their obligations. Seeing 7 per cent yields as a trigger may be magical thinking, but it has real effects. It was also needlessly encouraged by eurozone officials who strong-armed Ireland and Portugalinto financial rescues after their yields breached the 7 per cent mark.
Italy and Spain must therefore redouble their efforts to improve the factors that determine sustainability. So far, Madrid has been a great deal more energetic than Rome. Spain’s deficit-cutting programme is going well, even if the autonomous regions need to demonstrate more budget discipline. The government has shown a willingness to reform the rules that paralyse Spain’s labour market. The question mark remaining is over the banking sector. A long-overdue consolidation is taking place, but the public finances are still vulnerable to unpleasant surprises in banks’ asset values. Madrid should cap the amount of any future bail-outs of banks once and for all.
Italy needs to retrieve the fiscal tenaciousness it demonstrated in the 1990s. Its large debt burden makes it imperative to respond to yield rises with even greater budget discipline. The recently passed budget disappointed by scheduling most of the effort until after elections due by 2013. Rome should revisit this to frontload more deficit cuts. But the greatest failing of Italy under Silvio Berlusconi, prime minister, has been the lack of effort to restore Italy’s growth rate. Structural reforms to boost competition and reduce bureaucracy can wait no longer.
The greatest responsibility for dispelling market fears lies with the two countries themselves. But even if they do everything necessary – and Spain has come close – this may still be insufficient. The market has its reasons that reason cannot know: if enough traders find Italian and Spanish bonds too risky, their selling of their holdings can make their fear a reality.
Rome and Madrid cannot stop this. But the eurozone as a whole can. Its leaders agreed last month to unlock their toolbox by letting the European financial stability facility buy sovereign debt in secondary markets pre-emptively. But they have yet to implement their agreement; and they failed to boost the EFSF to a size commensurate with the problem. This is a dereliction of duty.
We may yet be spared a full assault on the eurozone’s southern front. But if one comes, it would be better to be prepared.