Too Big To Fail; Too Big To Bail

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In last week’s entry I pointed to the U.S. stock market’s daily Pavlovian responsiveness to stories and rumors coming from Europe. That action continues this week with the focus shifting from Greece to Italy. Greek Prime Minister Papandreou’s government has collapsed, and opposing parties are scrambling to find enough points of agreement to coalesce around a unity candidate. Virtually no one expects such a government to last. The desperate hope is that the politicians can simply assemble a sufficiently credible coalition in support of the promised austerity measures, so that the next tranche of bailout money will be released before Greece runs out of funds.

Despite the immediacy of that concern, the 800-pound gorilla that has taken its place in the middle of the room is Italy. Italy’s economy and debt levels are many times larger than those of Greece.

Last week I lamented that Italy’s ten-year bond yield had risen to 6.4%, a level that strongly called into question the government’s ability to service its debt and grow its way out of financial distress. Conditions have since worsened. On Wednesday, fear pushed that yield up to 7.25%. It is noteworthy that reaching the 7% threshold was a red flag warning that preceded the necessary bailouts of Greece, Portugal and Ireland. Italy’s political situation is in obvious disarray, and there appears to be no compelling voice strongly advocating the severe austerity measures needed to bring the country into compliance with Eurozone financial standards.

Italy’s growing crisis dramatically compounds the rescue problems that have so far bedeviled Eurozone finance ministers and heads of state. Italy’s failure to roll over its maturing debt at a manageable rate of interest would send shock waves through the European economy. On the other hand, in a weak economic environment, there is virtually no chance that the combined Eurozone members will provide enough rescue money to get Italy over this hurdle.

If the markets push Italy to the wall, there is no European entity (as currently funded) capable of coming to the rescue. The European Central bank could be further capitalized, but that is unlikely given the already-existing financial pressure on its members. Or the Eurozone could agree to permit the ECB to print enough money to paper over the problem. Such a solution, however, runs painfully against the grain for Germans, who retain in their DNA an abhorrence to inflation that decimated the value of their currency in the 1920s. If Germany doesn’t want it, it isn’t going to happen.

That leaves a coordinated worldwide solution as the only realistic possibility. Getting the International Monetary Fund (17% U.S. funded) and the U.S. Federal Reserve on board with the ECB appears to be the only option for pooling enough financial firepower, should Italy need rescue. Could you imagine getting approval of such a monetary commitment if it were put before voters in the United States? Inconceivable in today’s tough times. Should Bernanke, Geithner and the boys pledge U.S. money to such an effort, it would be yet another example of “We know better than you do.”

If you oppose the parade of financial bailouts, as I do, I urge you to let your voice be heard in any way you can. Don’t allow our government officials to reward the profligate at the expense of the prudent.

And if Italy is temporarily rescued, Spain is waiting in the wings. And how are we going to solve our own debt crisis here in the United States?