Investor panic puts Italy on the precipice

COMMENTARY Italy may be a goner. Prime Minister Silvio Berlusconi's offer to resign yesterday isn't stemming investor panic about the country's financial stability, with interest rates for government debt in Europe's third-largest economy on Wednesday topping 7 percent. That is dangerously close to the red-line, as one expert tells the WSJ:

"The instability of Italy's political situation could increase market anxiety levels before rates got even close to double digits, and at 7 percent or 8 percent Italy could find it was unable to raise sufficient money on the bond market," said Laurence Boone, European economist at Bank of America Merrill Lynch. "In short, a confidence issue could turn into a liquidity issue."

In another ominous sign, short-term Italian bond yields surpassed long-term rates. Such "inverted" bond curves preceded the capital markets chaos elsewhere in Europe. Right on cue, the latest rumbling in Italy caused stock markets in the U.S. and Europe to plunge.

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In other words, Italy is caught in a vicious cycle. Financial markets are losing faith that the country can repay its debts, which at 130 percent of GDP is the second-highest in Europe, after Greece. Specifically, surging bond yields in Italy could force traders to post more collateral. That drives yields up even further because investors demand a higher return to offset the greater risk of holding the debt. Fear leads to higher borrowing costs, which intensifies investor anxiety, and so on as government finances spiral downward.

Market psychology also can make mincemeat of political "solutions" to economic problems. Berlusconi's exit (or whatever he's doing, since it's not exactly clear) is supposed to send a message that Italy is willing to take whatever steps are necessary to slim its budget. Clearly, financial markets aren't buying it.

That may be because financial markets aren't convinced Berlusconi is serious about falling on his sword. More important, investors appear to have absorbed a vital lesson about government spending cuts and other "austerity" measures as a way to kick-start growth amid a global economic slowdown: It doesn't work. Not in Greece, not in the U.K., Italy, Spain, Portugal and other ailing European countries seeing their GDP decline after such belt-tightening. Not in the U.S, either. Will "expansionary contraction" work in Italy? Right.

Economist Kash Mansori, writing in The New Republic, sums up Italy's quandary:

"Political leaders in Germany and France are pressuring Italy to cut government spending in order to further increase its primary budget surplus. But if market psychology continues to drive Italian interest rates higher, the dollars Italy saves through spending cuts will be overwhelmed by its higher borrowing costs, which are far greater in euro terms than any cuts in government spending that could realistically be achieved. And so Italy's budget outlook will still look worse rather than better, the market will remain unwilling to lend, and Italian borrowing costs will continue to rise. To make matters worse, austerity will lead Italy's economy to shrink, just as it has done in the UK, Greece, and elsewhere, making the trajectory of Italy's debt burden look even less sustainable."

By damaging already wounded economies, austerity also tends to cause political turmoil. That puts a solution even farther out of reach. All European officials can do now is expand the "ring-fence" they have sought to place around the region's "peripheral" economies in hopes of sealing off larger states like Italy. Each time such measures fail to stop this "contagion," of course, financial markets put even less stock in Europe's ability to cure the disease.

If that pattern continues, say "arrivederci" to the eurozone.