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Wednesday, November 9, 2011

Greece, Italy, and fiasco

While in the UK last week, all the news was about Greece. For some of the background, read this article. It's scary.

Greece, as bad as its finances are, has only 11 million people and a GDP of roughly $300 billion. Losing the Euro or being kicked out of the EU altogether would be bad for those 11 million people, who would return to a second-world existence; but it wouldn't be catastrophic for Europe at large.

Italy, on the other hand, has 61 million people and a GDP of roughly $1.8 trillion. If the sovereign debt of Italy goes under, the damage cannot be contained inside Italy. That's why the U.S. stock market dropped 3% today on top of sharp losses yesterday. I am not a fearful person, but the truth is that when financial markets begin to unravel -- as they did in 2008 here -- nobody knows where the bottom is. All one can see or feel is muck around one's toes.

The short-term sovereign debt of Italy has become so risky that lenders are demanding 7% interest. By comparison the short-term sovereign debt of Germany -- in the same currency -- has less than a 1% interest rate. That kind of spread is unprecedented, and it will tear the Euro apart if it persists. What bankers fear is a deep "hair cut" that would make Italian sovereign debt, like sovereign debt of Greece (and Ireland and Portugal), worth less than 60% of face value. When that happens, the balance sheets of the banks that hold large amounts of Italian debt go under water. Technically the banks could become insolvent. Not only does the market value of the banks' common stock fall to near zero (triggering margin calls and a loss of personal or institutional wealth), but the monetary system freezes up because no solvent bank wants to send money to an insolvent bank.

The difference between the U.S. and Europe is that the Bush and Obama administrations, the Federal Reserve, and Congress acted quickly and put a temporary foundation underneath the New York financial markets. It worked, the New York markets stabilized, and for the most part the U.S. banks were able to shed their toxic assets. Decision-making and follow-through are so difficult in the EU, however, that many European banks remain loaded with toxic assets -- and they're becoming increasingly toxic every day.

Spain is still out there, too.

I don't know how this will play out, but clearly Europeans face deep questions about the very nature of the EU.