Charles Wyplosz on Italy’s “Bad Equilibrium”

Charles Wyplosz issues a stark warning here – a warning well worth heeding.  

But is he too pessimistic?    The fact is that the ECB has the power to cap bond yields.   With bond yields capped at a reasonably low level – say 4.5 percent – the Italian government should be able to avoid default, even with a formal adjustment programme of structural reforms and fiscal adjustments.   I doubt the programme would have to involve much beyond what the country is already doing.   Mario Draghi has held out the promise – albeit maybe a bit too vaguely – of such support in return for conditionality.   All sides have to move.

21 replies on “Charles Wyplosz on Italy’s “Bad Equilibrium””

This is distilling into politics. One one wing you have those who think the status quo in the various peripheral states should essentially be maintained – they are often domestic, peripheral commentators. On the other you have those that think it is necessary (and desirable) for core ‘values’ (or whatever) to be imposed before removing market discipline from the bond markets (again).

This is now European politics.

Grumpy it was always politics. That’s why it’s called political economy. And that’s why we need to remind ourselves that at this juncture one should at least wonder at the politics of any and all commentators in thr public domain. That’s not to say their comments wont be j urged in terms of their merits but st the end the politicos will decide.

“I doubt the programme would have to involve much beyond what the country is already doing.”

The idea that countries in conditionality programmes are not doing “much beyond what the country would already be doing” is one the great euphemisms of the crisis. They are doing what they are told, backed by potentially devastating sanctions, and one of the things they are being required to do is to pretend that they would be doing these things anyway.

No, he is not at all pessimistic, and quite perceptive.

“The recession is opening up another vulnerability. It inexorability deteriorates the ability of past borrowers to pay up. The volume of non-performing loans is bound to increase steadily.”

Anybody working in the real economy is watching this phenomenon on a daily basis. The banks too, know it to be case, but as usual are economical with the truth.
Despite a 4 billion reduction (from 108 billion to 104 billion) in total loans outstanding, BOI’s impaired loans increased from 13.4 billion to 15.4 billion in the period from Dec 2001 to June 2012.
So much for austerity.

Austerity, or at least the version of austerity mandated, is doing exactly what it said on the tin. There should be no great surprise at that.
Of course there was and is a different version of ‘austerity’, that would have balanced the books, i.e Taxes designed to hit high earners and high savings, that would have had very little recessionary impact, but that version of budgeting is ruled out by another ideology, just as insidious and damaging as the German version of austerity.

“The fact is that the ECB has the power to cap bond yields.”

Pre Draghi, the ECB was no more than a subdivision of the Bundesbank, with Trichet in addition having a direct line to French banks, making sure to see them right.
Draghi has done well since his arrival but his seemingly deliberate humiliation by the Bundesbank, following his London remarks shows what a sorrowful and impotent position he is in.
Approx two days before his last conference, he felt it necessary to have a formal meeting with Herr Weidmann to try to get him onside, or try to get authority to do what the should be doing.
Does anybody recall Trichet having to come to Dublin for a meeting with Mr Honohan, to get his approval, when Ireland was about to be skewered by the European powers.

So , “The fact is that the ECB has the power to cap bond yields”, may be true in theory but brings to mind the old saying:
‘We have the power to call the dead from their graves, but will they come?.

There should be no doubt or no equivocation about what is causing the European recession that is destroying a generation of young people and there should be no doubt about who is mandating the policy that is causing that recession.

It is up to Europeans to stand up to Germany and tell them for everybody’s sake to go back to their beloved DMark and leave the rest of Europe its sanity and its future.

While capping at 4.5% may prevent default under current circumstances I am sceptical that Italians are going to stick with the programme long term. Like the Spaniards they may find that even getting a reasonable level of support from the ECB is just going to be too late.
Can Spain, Italy and Greece generate enough growth to prevent social and political turmoil which might force them out anyhow.

From Irelands point of view though. We have extremely high national debt which prevents us from using Stimulus. Though we have silver linings.

1) our openness means austerity isn’t as painfull as it would be if we produced more of what we consumed
2) we’re edging slowly toward a balance budget.
3) the drop in euro to dollar/sterling has allowed us to regain competiveness and not cut wages of those still employed. Which is good because we had no intention of cutting wages anyway.
4) The possibility to shift some debt to other nations and/or the wonderful ECB.

Though we have a serious personal debt crisis related to a collapse in property prices, so all staying the same we’ve a high chance of seeing the nth recapitalization of our wonderful banking system as well as a first of Nama. Heaping yet more debt on to the National balance sheet. The personnel insolvency bill seems to be designed to kick this bad news as far in to the future as possible.

Unfortunately of course all our trading partners are doing the austerity thing too.

So we need

1) Massive national debt write off.
2) We also need to restructure our economy to create jobs for and retrain those that were bribed in to the construction industry during the ‘boom’
3) We need those countries that can to stimulate ie More core countries buying Irish goods/services.

On 1, the durys out. On 2, we can currently only ‘reform’ what we have, so far we’re failing to tackle the cost of business here. Rent seekers, electricity/legal/medical/child care costs are all above average or near top in Europe. On 3 we’ve no or little control.

@John McHale ” With bond yields capped at a reasonably low level – say 4.5 percent”

In what maturity?

Draghi has a very important role but he cannot magic up growth for Italy.

June was a good month for exports ex-EU27 and of course the domestic situation has cut import demand.

The big black economy will also help in the short-term. Household debt to GDP is half the public debt ratio.

In a decade, Italy grew at just 3% and net exports contributed nothing to growth despite Italy have Europe’s second-biggest manufacturing sector.

High youth unemployment has been a 40-year long problem.

Absent external pressure or an internal collapse, there would be no prospect of change.

I tend towards the view that a loss of bondholder confidence is God’s own way of preventing over-borrowed states from imposing giant primary surpluses on their people, and telling bondholders who have over-lent that they won’t get their money back.

A country already running a large primary surplus may leave its people better off, over both the short and long term, if it allows the loss of confidence to reach its natural conclusion, rather than scrabbling about trying to frustrate the effective functioning of market discipline.

I am no expert but this strikes me as odd. SMP purchases didn’t bring in spreads to any meaningful extent, neither did the LTRO’s. Why would an investor buy a bond at 4% that he is clearly not willing to buy at 6%? More to the point there is a large difference between US QE and QE a la ECB. The Fed is buying AA rated securities. The ECB would be basically taking junk bonds onto its balance sheet. Hardly conducive to a stable currency.


For a start Spain and Italy are investment grade, not junk bonds.

The LTRO relied on the independent private banks to do the ECB’s dirty work and was (at best) an indirect attempt to reduce sov yields. In any case, the primary purpose of the LTRO was to reduces banks’ liquidity problems.

The SMP was a half-hearted and explicitly limited scheme that was accompanied by bluffing by the ECB and bad-mouthing of the underlying bonds. In addition, the ECB insisted on seniority in all SMP purchases. Investors need to know that the central bank is fully behind the sovereign. Which brings me to….

The very fact the the UK, the US and Japan all have their own central banks actually reduces their credit risk. The US, UK and Japan all have higher debt than Spain and Italy runs a primary surplus and has very low levels of private debt, which cannot be said about any of the others. If the UK was in the Euro it wouldn’t have been able to depreciate its currency during the crisis and, suffering from a burst property bubble and bust domestic banks, would probably have had to endur a fate similar to Ireland’s or Spain’s. In short, if the UK was in the Euro and subject to the prevarication and incompetence of the ECB, it, too, would probably have a credit rating of BBB or A- by now.


I am sure he meant that the ECB promising to buy enough bonds to never let Italian (10 year as the benchmark) bond yields go below 4.5% would be enough for them to stay sustainable.

Sorry if you got that already!

Sorry didn’t mean money transfers.

Europe could work but it needs values. For example healthcare could be supported at European federal level. It would bring down overall costs and lead to standardisation but also send out a message that Europe cares. Will it happen – don’t think so

@ All

An element in the overall deal is the oversight to be granted to the ECB.

The Commission has briefed Handelsblatt on what its proposals to be tabled on 11 September will contain.

Three very contentious elements;

(i) all banks in EA covered

(ii) non-EA remain subject to national supervisors

(ii) Commission wants to use Article 114 (TFEU) which would involve European Parliament rather than Article 127.6 which would not (as agreed by EA summit).

re the three issues:

1. All banks covered (EA). This is the only way to go. Opt-outs for any reason, be it size or function, would have made a difficult job impossible.
Consider a policeman who can only arrest over 30 year olds. It doesn’t take much to envisage the over 30s getting the under 30s to do the dirty work. My hands are clean, etc!! One can already see how banks use offshore, tax havens etc to deal with illicit funds etc.

2. Makes perfect sense. Ultimately one has to be able to shut a bank or rogue business down. The ECB cannot or would not be able to do this, outside of EA, without excellent and continuing intra-national agreement. Not much sign of that these days, or perhaps any day.

3. I don’t have any knowledge of this area but it seems like the Commission would like to begin to bring things back from Merkozy like quangos and other similar type ad hockery that has been in vogue over the past few years.

@ Joseph Ryan

Some comments.

The first issue is a major problem for Germany as they argue that the Mom and Pop local banks in Germany are not a systemic threat. The very oppposite is, of course, the case.

The second issue is a good deal more complex than you suggest as several of the major UK banks are systemically important.

The third issue is an intriguing one and designed, it seems to me, to call the bluff of Berlin with regard to the “democratic legitimacy” of the new arrangements about which German politicians make so much noise.

Just for info, average Italian bond yield (from 1 year out) is 4.83% at close of business on 16th Aug; one has to go out past 6 years to find a yield over 4.50%. Average tenor on Italian bonds is 8.6 years. (All data via Bloomberg and, subsequently, Bank of America/ML index data. It excludes linkers and T-bills).

Rollover risk is obviously huge if funding in short dates – and Italy of all countries should be aware of this. They had for many years a legal proscription on borrowing longer than, I think, 2 years, which was intended to force governments to run balanced-ish budgets. They didn’t, and Italy became a sitting duck for years, prey to every upward shift in rates, every individual rollover offering an opportunity to short both the bonds and the currency.

That said, I’m not overwhelmed by the concentration on funding costs on 10-year yields. Total German funding costs are, for example, about 50% or less of their current 10-year yield (which is about 1.50%). Yield curves matter, and so does average maturity of debt. (I know, issued debt carries an immutable future cost related to yield levels at issuance, but the operating assumption tends to be that future issuance will maintain average existing tenor. This however is neither necessarily true nor advisable.)

@ All

The view from Spain! (Google Translate provides a good translation).

The Spanish minister is overlooking some rather obviois points. Germany has managed her economy well, Spain has managed her economy badly notably in (i) losing control of spending by regional governments (ii) allowing an unprecedented property bubble to develop. This is the explanation for the divergencot in spreads, not some malfunctioning of the euro.

Can the ECB really save the euro? This is an imposed currency system which requires millions in the periphery suffer large unemployment. Once the ECB owns 30% of Italian bonds, and 50% of Spanish bonds, will markets feel comfortable that the remaining outstanding bonds are safe?, will recessions in those nations stop? and will markets decide the euro is a great system afterall such that risk premiums will fall sharply? Charles is far too confident that bond-buying at the ECB is enough to calm this situation.

Comments are closed.