Will she or won’t she?
That’s the question that anyone who cares about the future of Europe is asking as the Italian debt crisis threatens to return with a vengeance, if it has not returned already. Will German Chancellor Angela Merkel, the protector-in-chief of the euro zone and the effective boss of Europe, find a way to defuse the Italian crisis?
If she doesn’t, the chances of Italy crashing out of the euro zone, which were essentially zero before the March election when two anti-establishment, Euroskeptic parties stole the show, can only rise. It’s impossible to say what those chances are today, but they are certainly somewhat north of zero.
The bond market said so on Tuesday. The trading session was a bloodbath for Italian public debt, even worse than the worst days of 2011 and 2012, when Italy seemed bent on modelling itself after Greece.
Italian two-year and 10-year bond yields soared like never before (yields and prices go in opposite directions). In the morning, the two-year bonds blasted through 2 per cent, for a phenomenal rise of 150 basis points or 1.5 percentage points. The 10-year bonds climbed by 67 basis points, reaching 3.33 per cent.
The bonds later recouped some losses, as their yields fell back from dizzying heights. Still, the 10-year bonds yield finished the day up 47 basis points, at 3.13 per cent, for a truly ugly one-month rise of 141 basis points. The Italian sell-off rattled the markets across Europe, with German, British and Italian stock markets taking a dive, the euro selling off and bond yields in Spain, Portugal and Greece climbing.
Remember contagion? It seems to be back, grazie Italia.
As stories of the possible return of the Italian nightmare filled the media, the sober-minded governor of the Bank of Italy, Ignazio Visco, warned that Italy was playing with fire. In his annual speech on the Italian financial system, he said that Italy was “a few short steps away” from losing “the asset of trust.”
It was a not-too-subtle warning to the two populist parties, the Five Star Movement (M5S) and the League, which came within moments of forming a government on Sunday, only to see their hopes dashed when President Sergio Mattarella rejected their choice for finance and economy minister. Mr. Mattarella decided that the populists’ candidate, Paolo Savona, an avowed Euroskeptic, was perhaps too Euroskeptic for his tastes.
He said he would rather not have a candidate who “could probably, or even inevitably, provoke Italy’s exit from the euro,” which was a pretty blunt admission that the euro is not irreversible.
Mr. Mattarella’s save-the-euro gambit so far seems to have backfired, as the surging bond yields proved on Tuesday, the day after he appointed a former International Monetary Fund official, Carlo Cottarelli, as interim prime minister before a snap election as early as the fall. Investors are taking the view that the Euroskeptic, populist parties could come back stronger than ever. The opinion polls say as much.
Which brings us back to Ms. Merkel. In 2012, no doubt with Ms. Merkel’s implicit or explicit approval, European Central Bank boss Mario Draghi announced that the ECB would do “whatever it takes” to keep the euro intact. In came the pledge to buy, in unlimited quantities, the bonds of any country that was in danger of getting shut out of the debt markets. The program was never used but succeeded in dropping bond yields across the euro zone, especially those in Italy, whose yields had almost reached the levels that triggered the Greek bailout.
Three years later, in came quantitative easing (QE), the €2-trillion-plus ($3-trillion) program to buy sovereign bonds to push down their yields even further, prevent inflation from turning negative and stimulate growth. In effect, it was a soft, back-door bailout of Italy (and Spain, to some degree) and it worked, or at least it did until M5S and the League stormed parliament.
The problem is that the QE program introduced by the ECB is winding down and should finish early next year. When that happens, Italian bonds will have no protector. Some economists and strategists think that the ECB, again with Ms. Merkel’s approval, will find a way to keep the QE program alive, all the better to keep Italian yields from blowing through the roof, spreading contagion and possibly handing the euro zone its second existential crisis this decade.
The bigger question is not whether she will quietly urge the ECB to keep QE alive, but the opposite. Maybe she would be happy to see the Italian debt markets come close to destruction, gambling that the new populist government (if one is formed after the next election) would drop its anti-euro rhetoric in a hurry and announce policies to protect it. The risk – and it’s a big one – is that the populists could do the opposite, arguing that the soaring yields are proof that the euro is a rigged game against the Italian people, so it’s time to hit the road.
Ms. Merkel, with the ECB at her side, may yet face their toughest test yet in keeping the euro zone intact. Into her fourth, and presumably last, term, Ms. Merkel was hoping for a victory lap. Instead, she may have to choose between saving the euro zone once again or conceding defeat.
Eric Reguly