The European Debt Crisis - Part II

What we are all watching unfold right now is a complete and total financial nightmare for Italy. Italy is the eighth-largest economy in the world and the fourth largest in Europe. Its debt totals more than $US2.5 Trillion… 

To put it in perspective, if you combine the value of Greece’s, Portugal’s, Ireland’s and Spain’s debts, the combined value is less than Italy’s debt all together!

Italy has long been regarded as “too big to fail”, but also, “too big to bail out”…. Its gross domestic product was over $US2 trillion ($1.97 trillion) in 2010. Greece, Europe's other basket case, has a GDP of $US305 billion….

Red Alert

Italian bond yields are soaring to incredibly dangerous levels, and now the yield curve for Italian bonds is turning upside down. So what does that mean?Normally, government debt securities that have a longer maturity, pay a higher interest rate. 

There is typically more risk when you hold a bond for an extended period of time, so investors normally demand a higher return for holding debt over longer time periods. But when investors feel as though a major economic downturn or a substantial financial crisis is coming, the yield on short-term bonds will often rise above the yield for long-term bonds. 

Chart – Italian Bond Yields

This happened to Greece, to Ireland and to Portugal and all three of them ended up needing bailouts. Now it is happening to Italy and Spain may follow shortly, but the EU cannot afford to bail out either of them. An inverted yield curve is a major red flag. Unfortunately, there does not seem to be much hope that there is going to be a solution to this European debt crisis any time soon.

We are witnessing a crisis of confidence in the European financial system. All over Europe bond yields went soaring today. When I finished my article about the financial crisis in Italy on Tuesday night, the yield on 10 year Italian bonds was at 6.7 percent. I awoke today to learn that it had risen to 7.2 percent.

Part of the reason why Italian bond yields rose so much on Wednesday was that London clearing house LCH Clearnet raised margin requirements on Italian government bonds.

In my view, 7% is a 'tipping point' for any large debt-laden country and is the level at which Greece, Portugal and Ireland were forced to accept assistance

Solutions?

German Chancellor Angela Merkel is saying that fundamental changes are needed.... “It is time for a breakthrough to a new Europe”.

So what kind of a "breakthrough" is she talking about? Well, Merkel says that the ultimate solution to this crisis is going to require even tighter integration for Europe....

That will mean more Europe, not less Europe.

What does this mean? And more importantly, will this solve the underlying problem?At the end of the day, governments are to blame and these governments need to be made accountable... to put it simply, governments need to reduce their reliance on debt - cut spending, increase taxes, reduce their need to borrow funds, cut deficits by selling assets (roads, infrastructure, utilities) and save more.....

Yes, central banks around the world need to help and restore investor confidence (even though, it’s not their underlying role...); but it is governments and the politicians that are running these governments, that are to blame.