Despite all the discussion around the situation in Greece the real fires are burning elsewhere. Though under the current economic and political setting a disorderly default of Greece would be enough to tear apart the euro, the final blow to the single European currency can in fact be delivered by either its 3rd largest economy, Italy.

Graph 1. Data from Reuters

Italy is too big too fail but it also is too big to bail. French and German banks are heavily exposed to Italian debt, with German banks holding an estimated 118 billion euro of Italian debt, while French banks hold around 284 billion euro (Graph 1 on the right is in US dollars and counts in billions). The debt that private banks hold is staggering and shows that if Italy was to default or to significantly restructure its debt, core European banks would run into serious trouble. Given that European banks are already quasi-bankrupt and will in a few months time come to need for recapitalizations, a hit from Italy is certainly going to be fatal.

Graph 2. Data from the ECB

Italy, is the living proof against the narrative that large fiscal deficits are the problem in the eurozone and thus austerity policies are urgently needed to reduce such deficits (the fiscal discipline delusion) . As seen in the table on the right (Graph 2) Italy has a budget deficit at around 4.6% to GDP, compared with an average 6% at the eurozone, 5.4% from Netherlands and more than 7% in France. What other European partners are asking from Italy right now, i.e. austerity, is a narrow-sighted demand that only seeks to reduce the budget deficit, at the expense of diminishing growth, which at this point would only push the country deeper into the debt vortex. What Italy needs (and the euro area as whole) is growth and this will never come from austerity, especially when such policies are applied by all member-states simultaneously, effectively leading to a disastrous fallacy of composition, where no one spends and everyone cuts. Only growth will push the Italian and the European cart out of the mire of self-fulfilling recession.

What most analysts point out about Italy is the country’s debt to GDP ratio that stands at around 120%, when the Stability and Growth Pact envisages a maximum of 60%. Italy’s credit rating was downgraded recently, primarily due to such debt levels. Even though Credit Rating Agencies are less influential amid this crisis, because they were utterly oblivious of what was actually happening prior to the Great Recession, the credit rating downgrades are among the signals that the situations gets worse, not better.

For me the real problem of Italy is not its outstanding debt. What worries me the most about Italy is the annual real growth rate, which has been on average less than 1% for the last decade (see chart 3 below from 2001 to 2011). This combined with the current recession in the entire euro area and the overall slowdown in the global economy, suggest that real growth will at best be just above zero (the IMF estimates 1%), thus diminishing any hopes of reducing the debt mountain which stands at approximately 1.8 trillion euro.

Graph 3. Italy Real GDP Growth Chart by YCharts

Currently the country borrows at exorbitant interest rates of more than 6%, which means that in order to pay back debt and interest, Italy must have a growth rate of more than 6.1% which understandably is a utopia. In a November 8 report from Bloomberg we get the following on the matter:

Italy’s 10-year bond yield rose 11 basis points, or 0.11 percentage point, to 6.77 percent at 5:07 p.m. London time, the most since the introduction of the 17-member currency in 1999.

Note that these interest rates are kept at such high levels despite the constant intervention of the European Central Bank in the secondary markets. If these rates are to be maintained for a longer period of time Italy will come to the need of international aid, which practically means to enter a troika (EU, ECB, IMF) programme. However the EFSF, which is the vehicle that offers the funds, is ancillary in funding capacity. The EFSF has a total funding capacity of 440 billion euro, of which only 250 are available since the rest are reserved in the bail out programmes of Greece, Ireland, Portugal. In the latest summit, European leaders agreed to “leverage” the bail out fund to maximize its funding capacity up to 1 trillion. This would theoretically be achieved by guaranteeing the first 20% of the debt of Italy and Spain and use it to seek money from the private sector (how when European banks are practically bankrupt?) or from other sovereigns such as China, who would nonetheless attach all sorts of strings to achieve political ends, hence making an agreement quite distant. The plan to lever up the EFSF is going to die at birth. Here is part of what I wrote some days ago in my article titled “Only the ECB can be a bazooka in Europe – EFSF is a tower of cards“:

The EFSF which is supposedly the mechanism through which the fall of states will be prevented is from the outset an unstable structure as it relies on the guarantees of all member-states, including those who are in need of funds. In effect Italy, Spain and the three countries that are under bail out programmes, are providing guarantees to their selves, which are only accepted thanks to the combined gold-platted AAA credit rating of France and Germany, the eurozone’s two largest economies. The fundamental flaw in this structure is that France and Germany are in their selves in an unsafe position, since not even their own finances are very stable, either because of the exposure of their banks, which will indirectly bring the need for recapitalizations that have the effect of increasing public debts, or because of the burdens they carry with every country coming to the need of the EFSF, since those are the ones who provide the bulk of the funds.

The Achilles Heel in the EFSF is exactly its dependence on the triple-A credit rating of its two biggest contributors. France in particular has a banking sector that is heavily exposed to the debts of the European South, effectively raising questions of the capacity of the country to cling on to its excellent credit rating. These doubts are further reinforced by (i) the deterioration of Italy and Spain, with Italy being forced to lend money from the markets at an exorbitant interest rate of more than 6%, implying that the area’s third largest economy is making steps towards a bailout programme via the EFSF, (ii) the anemic growth in the whole euro area, which is to a large extend caused by the simultaneous fiscal austerity of all member-states, leading to a unique, euro-wide fallacy of composition, reinforced by the overall slowdown in the global economy. With respect to the latter, French President Sarkozy made reference to the need for further fiscal consolidation in his country, suggesting that the national economy will effectively enter a period of contraction. Understandably this setting, leads to a self-fulfilling path to depression, bringing down the whole system, unless some “Good Samaritan” (call me China) shows up. But a Good Samaritan will only show up, if the chances of saving the euro are also good, otherwise he will prefer to invest his capital in other ventures.

All of the above indicate that Italy and consequently the euro are in serious trouble and there seems to be no way out, especially under the current mixture of inane policies European leaders come up with from summit after summit. Apart from the purely economic data, what unsettles investors is the chronic political instability of Italy. The country is being governed in a cartoonist way, which raises fears over the ability of the political elite to provide any serious answers to the pilling problems.

Italy is too big to fail but also too big to bail. The economic fundamentals of the country are quite bleak, while the political system is very unstable. Adding to the internal malignancies of the Italian economy, the euro architecture as a whole does not have any means of backstopping the fall of countries, while the EFSF which supposedly has that function, is an unstable mechanism that could collapse at any moment, should the pressure on it increase. The systemic structure of the crisis (what I have been stressing for months now) is gradually becoming more apparent. Some might speak of contagion to the core. I would say that the Italian crisis is yet another manifestation of the broader crisis of the euro. Alas European elites continue to deny that the Euro architecture is what needs to be redesigned and instead continue to call for front-loaded austerity, hoping that by holding their breath, they will avoid contamination from the plague. If radical reforms and system-wide measures do not take place, the national crises will continue to deteriorate, effectively leading to the collapse of the euro, a single currency that was ill designed from the very beginning.

A macroeconomic overview of the Italian crisis | Protesilaos Stavrou.