Italy’s Crisis: Endgame for the Euro?

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You know the old saying: It ain’t over until the fat lady sings. Well, in the case of the euro zone debt crisis, that lady is Italy, she’s plump enough to cause quite a bit of trouble, and the orchestra looks to be tuning up.

We’re in the middle of yet another global financial rout, with stocks plunging around the globe, the sort of panic we’ve witnessed with sickening regularity in recent months. And as usual, Europe sits at ground zero. Italian government bonds got hammered on Wednesday, smashing through the important 7% level to a new euro-era high. Once Italy’s fellow PIIGS – Greece, Portugal and Ireland – broke through the 7% level, their borrowing costs escalated, eventually forcing them to seek European Union bailouts. Italy’s plight completely alters the situation in Europe, from a potentially manageable crisis to a potentially unmanageable crisis. Let’s put in perspective what’s happening here. Italy is not some half-baked emerging market or even a small, developed-world basket case like Greece. Italy is Europe’s fourth-largest economy; its bond market is the world’s third largest. And in a matter of no time, the liquidity in that market is drying up. And what’s scary here is that there may not be any way to rescue Italy if this spiral continues.

This is serious stuff, folks. For two years, grim voices in financial circles have been worried about just this type of scenario – when the debt crisis in Europe bit into the core of the euro zone, at the big boys that were too big to bailout. Now that worst-case scenario looks more likely to play out in real life. The endgame could be a renewed global financial crisis, a collapse of the monetary union, who knows. Here’s what economist Ken Courtis wrote me today:

In a sense Greece, Portugal, Ireland have been side shows. With Italy, we are moving to the main event. There is simply no way that Italy can conduct the massive refundings it has in the coming weeks with this situation…This is like when you see a movie of which you have read the initial scenario before hand. The film is different in places, perhaps even the sequence of scenes is changed, some it has been chopped, but you still recognize it…The scenario no one (except the shorts of course) has wanted to see unfold is now playing itself out before our eyes unfortunately.

So is this the “big one” we’ve all been dreading? The moment when the euro zone crisis spins out of control, and we all suffer?

Much of the answer to that depends on what happens in Rome in coming days. The debauched Silvio Berlusconi might have announced he will resign, but he hasn’t yet, and that effectively leaves Italy without a government. And we don’t know when it will have a government, or what sort of government it might have. Will there be an election? Will some sort of coalition be formed? We’re all left guessing. And when markets are nervous, they don’t like guessing. Without strong leadership, hopes for real reform in Italy are uncertain at best. Until Italy’s politicians show they are truly taking the crisis seriously, markets will continue to punish Italian bonds.

And where does that take us? Italy can likely handle elevated borrowing costs for a while without too much trouble. The bigger issue is liquidity. Because Italian debt is so large, the government needs to constantly tap financial markets to refinance itself. The big problem hits when Italy can’t do that anymore, or not at a cost it can stomach. Can Italy still get the funds it needs? We’re about to get an answer to that question in coming days. Italy is selling treasury bills today, and it has a bond auction Monday. Here’s what research firm Capital Economics said on that front in a report yesterday:

Wednesday’s surge in Italian government bond yields has catapulted the euro-zone crisis into a dangerous new phase. Precedents set by Greece and Ireland suggest the Rubicon have been crossed. If so, Italy’s cost of borrowing could now climb much more sharply, effectively locking her out of the capital markets. Even though Italy runs a primary surplus, this outcome could still force her to turn to official creditors to roll over her debt. But while Italy is considered to be too big to fail, she may be too big to save unless there is a major change of attitude towards resolving the crisis. Things could be about to turn very ugly.

And if Italy does require a rescue, is that even possible? The Capital Economics guys estimate Italy could require a bailout as big as 700 billion euros ($950 billion). By comparison, the bailouts of Greece, Ireland and Portugal have so far only added up to $370 billion. And where would the money come from? The euro zone rescue fund, the European Financial Stability Facility, is unlikely to have that cash. What does that mean? Capital continues:

So who would save Italy’s bacon if push came to shove? Core euro-zone economies are the obvious choice. But it remains to be seen whether they will put their money where their mouths are. If they don’t, a disorderly default by Italy and her eventual exit from EMU could be on the cards.

Ah, here’s where things get really interesting. Markets are not just testing Italy’s commitment to reform, they are testing the entire euro zone’s. The reason why we’re here is because the leaders of the euro zone have never backed their strong words with strong action. At every stage of the crisis, they have delayed and obfuscated, and dodged. They have never shown the sense of urgency needed to quell contagion; their “solutions” have always been half-baked and underwhelming. This whole mess could have been avoided if Europe had taken decisive action when the first stages of the Greek debt crisis began almost two years ago. Or if they had implemented measures to shore up the European banking system long ago. Or if they had made greater progress towards fiscal integration. If, If, If. Now we’re at another one of those put-up-or-shut-up moments. And what have we heard from the leaders of Europe? The European Central Bank has sat on the sidelines. German Chancellor Angela Merkel again called for reform of the euro and greater European integration. The solution to the crisis, she said, would be found in “more Europe, not less Europe.” More words with no action. If Merkel & Co. aren’t going to put up, then I’d rather they finally shut up.

Cue the fat lady.

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