Italy’s Made In Frankfurt Bond Crisis

With the Eurozone debt crisis spreading to perhaps include Italy, it’s crucial to understand that this particular aspect of the problem is “Made In Frankfurt.” Made, in other words, by the European Central Bank. The reason is that though Italy has a high level of outstanding debt, it’s also been running what’s called a “primary surplus” for years. That means that the government is taking in more in tax revenue than its spending on services and transfers. There is a budget deficit, but the deficit is caused entirely by the need to pay interest on the outstanding debt. This means that the rate of nominal Italian GDP growth is crucial. If nominal growth is high, then the debt:GDP burden will shrink over time from its high level. But if nominal growth is low, then the debt:GDP burden will spiral upwards unsustainably.

Wolfgang Münchau says it’s “hard to comprehend why markets decided to panic over Italy at this particular time.” But I don’t think it’s hard to comprehend at all. The European Central Bank raised interest rates on July 7, reducing NGDP growth throughout the Eurozone, and a week later the world’s eighth largest economy was facing an interest rate spike. Greece is insolvent under any scenario. Italy, by contrast, is perfectly solvent if and only if the European Central Bank allows for a recent level of Italian NGDP growth. But in order to contain inflation in Germany, the ECB wants to push Italian NGDP to a low level. That will force Italy to implement austerity budgeting, but austerity merely leads to lower growth unless it’s offset by lower interest rates. But austerity can’t be offset by lower interest rates if the European Central Bank insists on responding narrowly to conditions in Germany.

But no favors are being done to Germany with this approach. Germany is bigger and richer than Italy, but it’s not that much bigger or that much richer. There’s no containing a crisis that gets to Italy.