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What Plan for Europe? Rolling Over Italy's Debt

Felix Salmon writes:

Larry Summers’s inadequate plan for Europe: Summers has magically gone from “the debts incurred will in large part never be repaid” to “default to the official sector will not be tolerated so there is no reason to charge a risk premium,” without ever explaining how he got there from here.

It seems, here, that Summers has gone effortlessly from “you can’t just extend and pretend that there won’t be any default to the official sector” to “let’s extend and simply declare that there won’t be any default to the official sector.”

It’s precisely this kind of thinking that the tumult in Italian markets makes untenable. As the chart in Summers’s column makes clear, Italy has $471 billion of government debt maturing in less than one year. If the private-market window for Italian debt closes as it has done for Greece and Portugal, then the official sector would be on the hook to lend Italy that entire sum itself. And there’s simply no way that Europe can find that kind of money, especially not if it’s lending it out at close to risk-free rates...

I think that the smart Felix Salmon is wrong.

Let us parse this:

  1. Summers says that peripheral countries that cannot access the private market cannot repay their debts if the strong countries of Europe charge them high premium interest rates.
  2. Summers says that peripheral countries that cannot access the private market can repay their debts if the strong countries of Europe charge them the interest rates at which the strong countries can borrow.

Both of these statements by Summers seem to me to be true. It is often the case that debt loads that are unsustainable at high interest rates are very sustainable indeed at low interest rates.

Yes, this does involve a (rather large) interest subsidy from the strong countries of Europe to the weak countries.

But that is what the strong countries signed up for when they let the weak countries join their currency.

And I simply do not understand Felix's claim that "there’s simply no way that Europe can find that kind of money [$471B], especially not if it’s lending it out at close to risk-free rates..." Here is how it works:

  1. France and Germany loan the ECB $10B.
  2. France and Germany announce that the liabilities of the ECB are full faith and credit obligations of France and Germany.
  3. The ECB lends that $10B to Italy.
  4. Italy uses that $10B to repay $10B of Italian debt.
  5. The ECB goes to those who just liquidated their Italian debt assets and says: "Hey? Want to put your money in $10B of ECB obligations guaranteed by the German and French governments?"
  6. The ex-creditors of Italy become creditors of the ECB.
  7. The ECB lends another $10B to Italy.

And then repeat, until all the $471 billion has been washed into ECB debt or until Italian debt holders are happy rolling their debt over into new Italian issues.

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