Events in the Eurozone are unfolding at a more rapid pace than ever, with even the normally staid Economist warning that the Eurozone might break up, with “horrible” consequences. Indeed, while a Greek default might not spell disaster for global finance and might not even require Greece’s exit from the euro, Italy is the third-largest sovereign debtor in the world. Interest rates on Italy’s ten-year debt have leaped past thresholds some economists consider “unsustainable.”
Arguably, Italy is, unlike Greece, not insolvent, merely illiquid. It enjoys a primary surplus (revenues minus non-interest expenditures). The problem is that interest-rate rises themselves will push Italy into bankruptcy, as it cannot afford to float new debt to pay off old debt. From one perspective, Italy is suffering from (irrational?) investor contagion, a speculative attack based on a self-fulfilling prophecy. Another point of view is that investors are rationally anticipating an ECB “firehose to the Italian treasury.” The firehose, of course, is merely default in another form – but it may allow Italy stay in the Eurozone and keep European taxpayers off the hook (even as consumers get the shaft).
Furthermore, the Italian crisis came about principally because the Greek crisis has forced investors to update their expectations of sovereign defaults in the OECD. Until quite recently, it was commonly assumed that OECD governments don’t “hard default” and increasingly rarely “soft default” through monetization. For instance, most political economy work on the OECD has assumed that fiscal expansions – under independent central banks – drive currency appreciation! (Even before the crisis, that may have been wrong.) EMU only fortified this assumption. What we’re seeing is the gradual popping of the “government bubble,” as investors realize that rich-world sovereign debt is not the safe haven they assumed.
What about the U.S.? Treasury yields remain at near-record lows. By 2020, U.S. debt-to-GDP will surpass 120%, according to the IMF. That’s where Italy is now. Of course, Japan sits at 220, a massive outlier, and it’s never faced default. But during Japan’s Lost Decade, real yields on Japanese bonds were reasonably high due to deflation. Moreover, expectations of future growth were higher than current growth. That’s reversed for Italy – and arguably the United States. Falling growth means falling revenues and rising pressure on the debt.
Whether U.S. government debt is experiencing a bubble right now is anyone’s guess, but it’s odd for those who fault financial market irrationalities to hold up low Treasury yields as an indication that the U.S. debt situation is sustainable.