The Fate of the European Union

The magic number in the European Union (EU) is seven. Seven percent represents the level of interest on Italian bond yields where refinancing that nation’s debt becomes unsustainable, according to most economists. Although Greece was the problem child of yesterday, Italy has become the main focus for the simplest of reasons: while the EU’s third largest economy may been seen as “too big to fail,” it may also be too big to save – and the fate of the European Union itself likely hangs in the balance.

Thus, it was of little surprise on Wednesday, when Italian bond yields surged to 7.4 percent, that both the European and American stock markets tanked, with the Dow shedding 389 points before the day ended. Nor was it any surprise that both markets stabilized on Thursday, when those yields dropped below the 7 percent threshold.

But the reason they dropped is no cause for optimism, despite the fact that the European Central Bank (ECB) bought Italian bonds, and Italy also sold $6.8 billion of one-year bills at 6.087 percent. Why? ECB Governing Council member Klaas Knot said the bank can’t do “much more” to stem the debt crisis, and the yield on the one-year bills is as high as its been since 1997, up more than 2.5 percent from the 3.57 percent they were sold at during the last auction only a month ago. Thus, despite any temporary reassurances to the contrary, the European Union remains the epicenter of fiscal instability.

And the fiscal instability has led directly to the political instability. Both Greece and Italy are undergoing dramatic transitions, virtually simultaneously. In Greece, former ECB vice president Lucas Papademos was named Prime Minister after getting the go-ahead from Greek President of the Republic Karolos Papoulias, whose position is largely ceremonial. His appointment follows the resignation of current Prime Minister George Papandreou. Papandreou, who triggered an EU-wide crisis last week when he announced that he would allow the Greek people to hold a referendum on the latest bailout package, was far more conciliatory on Wednesday. In a nationwide address, he said Greece would do whatever it takes to pull the country out of its economic doldrums.

According to the latest plan, the new government will be sworn in today at 9 AM EST, at which point the names of the new, or surviving, cabinet ministers will be announced. A key question to be answered is whether or not Evangelos Venizelos remains Finance Minister. Reports are that Papademos has accepted him staying on. Once the government is sworn in it must be formally approved, with that approval dependent on how soon the new government can put together its policy declarations. This can be likely done relatively quickly because most of what the new government chooses to do is constrained by the conditions of the bailout agreement forged in Brussels on October 27th.

Since the new government is being formed precisely for the purpose of meeting those conditions, the 300 members of the Greek parliament will more than likely move to a confidence vote as quickly as possible. Greece allows for three days of debate, or more if a large number of members wish to speak. The vote of approval takes place at midnight on the final day of debate. If everything proceeds as expected–a big if–Greece could have a new government sometime next week.

In Italy, after much political wrangling aimed at saving his job, Italian Prime Minister Silvio Berlusconi is expected to formally step down on Monday. Berlusconi had originally pledged to relinquish power after the Italian government passed the same kind of austerity measures the EU is demanding from Greece. Berlusconi was undoubtedly hoping that government dysfunction, epitomized by a fist fight among members of parliament last month, would enable the embattled prime minister to hold on into 2012.

Enter the magic number seven, or more precisely, the 7.4 interest Italy’s bond yield reached on Wednesday. The infighting of entrenched politicians determined to preserve their status quo of power and privilege, which had held up the transitional process, could no longer be sustained. The breakthrough occurred yesterday when Mr. Berlusconi’s People of Liberties party backed the idea of an emergency national unity government led by a non-politician or “technocrat.” This idea was backed by the center-left opposition Democratic Party and a centrist bloc of parties as well, including Future and Liberty, and the Union of the Center, comprised of former Christian Democrats.

The technocrat most likely to lead the emergency government is former European Commissioner Mario Monte, who was promoted by Italian president and respected elder statesman, Giorgio Napolitano. The 86-year-old Napolitano named Monte a “senator for life” on Wednesday, and the technocrat-turned-politician is expected be on hand in the senate today for the passage of Italy’s latest austerity measures. The senate is expected to approve those measures today, followed by the lower house on Saturday. If all goes according to plan–once again, a big if–Berlusconi steps down by Monday.

Yet complications remain part of the mix. Berlusconi and the Northern League, a key party in his center-right coalition, want early elections instead of allowing a technocrat to lead the country. So does another center-left party, Italy of Values. Italian politicians are reluctant to be associated with the unpopular austerity measures that could reduce both their power and re-electability. Thus, whether or not the push to get Monte to the top of the transitional government succeeds remains to be seen, but the odds are in his favor: elections could take weeks and the ongoing instability would undoubtedly wreak more havoc with worldwide markets. Havoc that would undoubtedly send bond yields soaring once again.

Despite being a victim of so-called market forces, Berlusconi has no one but himself to blame for his ouster. He’s been elected three times, each time on claims he would reform Italy’s government. Yet Italy’s pension system consumes 40 percent of income tax revenue to care for Europe’s oldest population. The country is hampered by high wage costs coupled with low productivity, bloated government payrolls, a sclerotic bureaucracy, sky-high taxes and a dismal educational system producing one of the lowest levels of college graduates among first world nations. It’s manufacturing base has been usurped by Asians since the 1990s. All of the dysfunction was papered over by the formation of the EU and tsunami of cheap money that kept the system from collapsing.

Until now. Italy’s debt currently stands at 120 percent of GDP, second only to Greece’s unconscionable 162 percent albatross. And despite the lower interest rate on one-year bills, yields on five- and ten-year securities remain dangerously close to seven percent, due to a clash between France and Germany over a permanent EU rescue fund, and the ECB’s statement that its current market intervention is a temporary one. Adding to gloom is a statement by Barclay’s Capitol that Italy’s debt has reached a level that is “clearly unsustainable” and that the “EFSF [European Financial Stability Facility] is not an adequate safety net to insulate countries like Italy from contagion.”

The last bit is hardly surprising. Italy’s current debt of $2.6 trillion is more than that of the EU’s other troubled nations, namely Portugal, Ireland, Greece and Spain combined. Moreover, $272 billion in bond debt matures in 2012, along with another $147 billion in bills. The country’s first bond redemption comes on February 1st, when Italy must pay back $35.4 billion for debt sold 10 years ago.

Thus, Greece and Italy become the latest victims of European cradle-to-grave socialist excess, best expressed by Margaret Thatcher’s immortal bromide that such a system inevitably fails when one runs out of “other people’s money to spend.” As of now the transitional governments in both countries, even under the most optimum circumstances, seem to be nothing more than another attempt to kick the fiscal can–and the seemingly inevitable demise of the European Union–down the road one more time.

For those wondering which financial institutions are exposed to what, Barclays has come up with this handy chart showing European bank exposure to Italian debt. But the chart only tells half the story. While France has the most exposure and the U.S. comes in fifth, former IMF official Desmond Lachman illuminates the perils of international banking. “We may not have much direct exposure to the periphery, but we’ve got exposure to bets in Europe that have exposure to the periphery,” he explains. “And that means we’ve got exposure.” In layman’s terms it comes down to this: French banks have the greatest exposure to Greek debt, American and British banks to French debt–and American banks to British debt.

And who is most exposed to the debt of American banks? Perhaps the Obama administration might want to consider issuing “TARP 2” t-shirts to every American taxpayer. People on the hook for saving the entire world from the wretched excesses of socialism and the futility of Keynesian economic bailouts deserve something for their trouble.

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