Italy is neither insolvent nor illiquid

Italy's debt problems are not crippling

Regular readers of mine will know that, whilst I have long regarded Greece as certain to default and very likely to leave the euro, I have been very sceptical about the idea that there is any significant problem with Italy.

Recent days have seen a spiking up in Italian bond yields and a rise in the spread over German bunds.  Many commentators are now suggesting or implying that we are approaching the point at which a liquidity crisis for Italy might turn into a solvency crisis.

I find this an extraordinary claim, greatly at variance with the data and historic experience.  If it is in any sense true, that can only be for the most brutish of political reasons.

As I write, Italian ten-year bond yields are hovering at around 6.4 per cent, a euro-era high.  But why should we imagine, in any way, that that implied Italy had a solvency problem (or even a liquidity problem).  Consider the chart:

Here we see that recent bond yields do indeed constitute euro-era highs.  But before the euro, Italy had far higher yields and did not default.  If it did not default then, why would it default now?  Perhaps you think it used the period of low interest rates to accumulate extra debt?  Not so.  Current Italian debt-to-GDP is around 120 per cent of GDP, about the same as it was in the early 1990s.  And it isn’t accumulating additional debt especially fast – even during the recession itself, whilst deficits elsewhere rocketed into double figures, Italy's peaked at 5.4 percent in 2009 (less than, for example, France's 7.5 per cent).

So if even if Italy were simply to pay current market rates on its debts, it would be paying lower interest rates on no more debt than it serviced in the 1990s without defaulting. (Indeed, a recent Bank of Italy stress test suggested that debts would be sustainable even at 8%.) Why would it default this time?

Maybe you think that before the euro, Italy inflated away its debts?  Consider the following graph:

It is true that Italian inflation was higher in the early 1990s than today.  Then it was around 4 per cent, now it’s around 3 per cent.  Is that 1 per cent difference really the difference between defaulting and not – especially given that today’s interest rates are still 2-6 per cent below those in the 1990s?

Well, maybe real GDP grew faster then than it will now?  Maybe, maybe not.  In the seven years from 1992 to 1998, Italian GDP grew at 1.3 per cent per year in real terms — hardly stunning, but it didn’t default.

Finally, perhaps we worry that the capacity of the Italian population to deal with increased taxes to service Italy’s debts is less than in the past?  But by 2007, Italian household debt was only 30 per cent of GDP (versus around 60 per cent in Germany, nearly 70 per cent in the UK, and around 80 per cent in Ireland, Spain and Portugal). Whilst the UK, Ireland, Belgium and the Netherlands all have banking sectors of 350-450 per cent of GDP, the Italian banking sector is one of the smallest, relative to GDP, in the eurozone, at only around 150 per cent of GDP (only around the same size as Finland's).

I see nothing in any of these numbers to indicate that Italy would find any more interest in defaulting on its debts now than it did 20 years ago.  Of course, were the euro to disintegrate for other reasons – if, say, Germany left – then there is a fair chance that Italy’s post-euro currency would depreciate versus the post-euro German currency.  And if everyone else were then defaulting, perhaps Italy would join the party.

But, as matters stand, I see no reason why Italy should not simply live with the kind of yields markets currently demand of it.  I believe it should keep rolling over its debt, according to schedule.  It should, as it were, embrace the markets, saying “If the price is 6 per cent, I’ll pay 6 per cent.  If the price is 7 per cent, I’ll pay 7 per cent – because Italy is going to service her debts.”  If Italy embraces the markets, and shows its willingness to pay, then markets are likely to recover their confidence.

Italy should take no money from the IMF, and no money from the EFSF. Taking from either source would be little short of economic suicide, as it would indicate that Italy were not willing to pay interest rates available in markets that are perfectly serviceable.

Italy does not have a solvency problem.  Neither does it, in fact, have any particular liquidity problem — its bond auctions have shown no more tendency to fail than those elsewhere.  And the prices it needs to pay to roll over its debts are not so high as to threaten Italy’s solvency.

The euro has a problem, and euro problems elsewhere could become Italian problems.  And Italy may have problems of political organisation or comprehension of the issues.  But, within the euro, it is not insolvent.