European Monetary Union Update: Spain and Italy

     As expected, the contagion from the debt crisis in Greece, Ireland and Portugal is affecting Spain and Italy. More accurately, it is concerns in the market more than structural flaws that are undermining investor confidence in the two large southern European economies.

     Spain and Italy have undertaken austerity measures to ward off the contagion that spreads by exposure of banks to Greek, Irish or Portuguese sovereign debt, in addition to the general concern that too much public debt will prevent a government from being able to repay its bondholders, just as happened in those three states. Italy, which has the eighth highest gross domestic product in the world, but whose government also has one of the largest public debts (which is about 120% of its GDP), was praised by the European Monetary Union and others for its government’s recent passage of a second austerity package that included more spending cuts.

     But then, something happened. Investors became increasingly fearful that Spanish and Italian governments and banks would be unable to meet their financial obligations. As I had posted previously, although Spain was of much greater concern than smaller Greece, Ireland or Portugal, Italy is increasingly recognized as the firewall for the European Monetary Union. Italian Prime Minister Silvio Berlusconi reassured the world that Italy had undertaken the right fiscal measures, that its banks were well-capitalized and that the Italian people had relatively large savings. However, Berlusconi’s remarks that were intended to increase investor confidence in the face of market speculation against Italian banks were misinterpreted as not recognizing the risk. The market lost confidence that the size and pace of the measures were adequate, especially given Italy’s weak economic growth.

     Italian business leaders, the European Monetary Union and others have been encouraging Italy to accelerate its austerity program and to adopt policies that promote economic growth. ANSA reports that the Italian government is considering a package of reforms, such as spending cuts (especially to welfare), privatization, reduced regulation, acceleration of infrastructure projects, tax reform and increased prevention of tax evasion. There are also media reports that the European Central Bank will buy Spanish and Italian bonds, if the Italian government undertakes the necessary steps. If it does, the crisis might ease, but the dangers of too much sovereign debt in general and the euro project in particular will have been exposed.