The euro crisis was a financial crisis. Now it's a political crisis -- that could create another financial one.
Just when we thought we were out, the euro crisis pulls us back in.
This time, it's Italy and its inconclusive elections that are rocking financial markets. More specifically, it's the strong showing of comedian-cum-blogger-cum-candidate Beppe Grillo together with the umpteenth political resurrection of the reflexively corrupt Silvio Berlusconi that have stock indices slumping around the globe. Both are anti-austerity, and, to varying degrees, anti-euro -- a toxic brew that threatens to make bond markets queasy (though not because austerity or the euro are good for Italy).
Basically, the euro crisis was a financial crisis. Now it's a political crisis. And that could create another financial crisis.
Saving the euro requires a transfer of money between the rich states, like Germany, and the struggling states, like Greece and Italy. Germany says to them: You can have our money, or the European Central Bank (ECB) will print you some, but there's a price. The price is your government does whatever we want. And we want austerity.
This looks like a good deal for bond markets, at first, because, say, Italy avoids default, and Germany keeps the eurozone together. But it's an awful deal for ordinary Italians during a recession with massive unemployment, because austerity deepens the recession and increases unemployment. So international investors feel rewarded, and the public feels screwed.
The problem with screwing the public in a democracy are these little things called "elections", where the people have the occasion to tell their leaders to stop screwing them. Thus, you have a riotous election in Italy that bashes the high priests of austerity, and throws the immediate future of the euro into doubt. The bond market doesn't like that.
Italy's elections didn't deliver a a clear governing coalition, but they did deliver a clear enough message: The people are fed up with austerity. So fed up that they're willing to entirely disreputable figures to stop it. Now, it wasn't quite a wipeout for Italy's mainstream parties, but it was bad enough, and only looks to get worse as the economy does (which it certainly will if austerity continues). Here's how the elections broke down.
-- Mario Monti. The euro-establishment favorite is the candidate of determined austerity and structural reforms. A career non-politician, Monti was tabbed to lead the current caretaker government after the ECB more or less booted Berlusconi from office in late 2011. (More on this in a bit). For his part, Monti has governed as a "technocrat" -- code for hiking taxes, cutting spending, and liberalizing Italy's sclerotic labor markets. This is the kind of "tough medicine" Germany and the ECB want to see, but tough medicine tends to be pretty unpopular medicine in most places, and Italy has been no exception. Unemployment has risen from 8.8 percent to over 11 percent in the past year, and with it, Monti's ratings have sunk. Indeed, he came in a distant fourth, with barely 10 percent of the vote, in the recent elections.
-- Pier Luigi Bersani. The leader of the center-left party is the candidate of less enthusiastic austerity and structural reforms, but austerity and structural reforms nonetheless (or so markets hope). Bernani's Democratic Party came in first in Italy's lower house -- which triggered a rule giving it an automatic majority -- but came in a close second in the upper house, where there is no such majority trigger. It can't form a government on its own, but, as we shall see, it doesn't have a clear coalition partner either.
-- Silvio Berlusconi. He's baaack. After personally spending a year in political exile, Berlusconi's center-right party finished second in the lower house, and captured a razor-thin majority in the upper house. It's been a remarkable -- and, to markets, horrifying -- comeback for the billionaire media mogul best known for alternating between sex and corruption scandals during his previous stints as prime minister. Indeed, it was just over a year ago that the then-75-year-old Berlusconi looked politically finished -- and he had the euro-establishment to thank for it. In November 2011, the ECB basically engineered his ouster by letting Italian borrowing costs surge to ruinous levels as punishment for reneging on promised reforms. Berlusconi's coalition partner quickly defected under this financial blackmail, and Monti was installed in his stead. (The ECB, of course, then promptly brought interest rates back down). This quiet coup has unsurprisingly turned Berlusconi into a more vocal anti-austerity and anti-euro critic -- and that makes creating a workable coalition a big problem.
-- Beppe Grillo. It's not everyday a former comic starts a political party that wins the largest share of the vote, but today is apparently that day for Italy. This is not a joke. Grillo, a raunchy comedian turned blogger, founded his Five-Star Movement back in 2010 as an online protest movement against the political status quo, but since then, its brand of austerity-skepticism and euro-skepticism has turned it from punchline to powerhouse. That's a problem, since its economic agenda is incoherent, at best. Among other things, they want to: 1) hold a referendum on euro membership, 2) stop austerity, 3) stop paying its debt, and 4) move to a 20-hour workweek. Oh, and as Joe Weisenthal points out, Grillo wants to give every schoolchild free iPads too. Why not? Now, there's a smart case to be made for leaving the euro -- especially for an uncompetitive country with a primary surplus, like Italy -- but this is not quite it.
Grillo has already ruled out joining any coalition -- why destroy his anti-austerity brand? -- so that leaves Bersani and Berlusconi to come together if this round of elections isn't just going to beget a new round of elections. Markets are not pleased. Either a weak coalition with a weak commitment to austerity comes to power, or nobody does. It's been enough to send bond yields surging again.
It's not as if austerity has reduced borrowing costs by reducing debt levels. It's increased debt levels. You can see that in the chart below, via Paul Krugman, which compares austerity measures with changes in debt ratios in the euro zone. The more austerity you do, the more your debt increases.
In other words, austerity has hurt growth more than it's helped borrowing costs. But that still doesn't explain why it's helped borrowing costs at all. After all, why would a self-defeating debt spiral increase confidence? Well, it doesn't. At least not market confidence. But it does increase ECB confidence in the government.
Countries that borrow in a currency they don't control have a big problem. They can actually default. In other words, they can run out of it, since they can't print it. And that creates another big problem. If investors even think a country might run out of money, it's more likely to do so. They'll demand higher interest rates to lend to it, and those higher rates will put more strain on the government's budget -- making investors ask for even higher rates, and so on, and so on. It's a bank run on a country.
There's only one way to end a bank run, and that's with a lender-of-last-resort. Think about it this way. A bank run happens when lenders are nervous are other lenders are nervous that the bank will run out of money. But suppose there were an infinitely deep-pocketed lender who never gets nervous, and who you know never gets nervous, who threw as much money at the bank as it took to assuage these fears. The panic would pass. The ECB begrudgingly began backstopping countries in this way last summer -- which is when Europe's sovereign debt markets cooled down. As you can see in the chart below from Joe Weisenthal, yields on Spanish bonds receded from bankrupting levels as soon as ECB chief Mario Draghi promised to do "whatever it takes" to save the euro last July.
But there's a catch. The ECB conditioned this "whatever it takes" on countries carrying out austerity. In other words, the ECB said it will buy a country's bonds in unlimited amounts as conditions warrant -- what it calls "Outright Monetary Transactions" (OMT) -- only so long as that country cuts its deficit.
It's perfectly logical, and perfectly crazy. Let's tackle the logical part first. If countries know the ECB will always buy its bonds, they'll lose any incentive to bring their budgets closer to balance. The ECB, of course, doesn't want to underwrite reckless spending -- and so conditionality was born as a way around this moral hazard. But here's the crazy part. The ECB (and Germany) have given southern Europe a way to avoid Armageddon today, but not tomorrow. Europe has, albeit reluctantly, done whatever it takes to keep the euro from falling apart, but it hasn't done anything to keep growth from doing so. The ECB hasn't done any big monetary stimulus, and Germany hasn't done any big fiscal stimulus. This combination of mega-austerity in southern Europe, less austerity in northern Europe, and too tight money everywhere has been an avoidable catastrophe. Europe has averted the panic, but not the depression.
And now the depression is bringing back the panic. Voters across southern Europe have lost patience with policies that condemn them to perma-slump -- and markets worry that will make the ECB lose patience with southern Europe. In other words, markets are pushing up Italian borrowing costs now not because they want austerity, but because they know the ECB does. If the past is any guide, the ECB will probably "punish" Italy by letting it dangle for a few weeks -- passively watching its bond yields rise to danger levels -- until its politicians fall back in line.
But like all unsustainable things, this will eventually end. Voters in southern Europe will eventually fear never-ending depression more than they fear leaving the euro. It's already begun. Politicians like Beppe Grillo in Italy and Alexis Tsipras in Greece are only getting more popular the more austerity and tight money destroy their economies. They're smartly biding their time, and avoiding any actual responsibility, while Europe's political mainstream discredits itself by championing obviously failed policies. The ECB and Germany need to give southern Europe a plausible way to start growing again so unemployment will come down -- and not over some hazy long-run, when we're all dead -- or the euro is doomed. The cranks will win.
Europe seems oblivious. As Jonathan Portes points out, Olli Rehn, the Vice President of the European Commission, criticized economists for criticizing austerity. The eurocrats think the failed policy isn't the problem, but rather other people pointing out it's a failed policy.
That's almost as bad a joke as Beppe Grillo winning the most votes in Italy.