With interest rates on its sovereign debt surging well above seven per cent, there is a rising risk that Italy may soon lose market access. Given that it is too-big-to-fail but also too-big-to-save, this could lead to a forced restructuring of its public debt. That would partially address its “stock” problem of large and unsustainable debt but it would not resolve its “flow” problem, a large current account deficit, lack of external competitiveness and a worsening plunge in gross domestic product and economic activity.
To resolve the latter, Italy may, like other periphery countries, need to exit the monetary union and go back to a national currency, thus triggering an effective break-up of the eurozone.
The eurozone can survive with the debt restructuring and exit of a small country such as Greece or Portugal, not major economies such as Italy and/or Spain. Unfortunately this slow-motion train wreck is now increasingly likely. Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster. Read more