It is not pleasant but the alternative of leaving the euro area is worse.
The Greeks were taken to the edge of the cliff last year and they didn’t like what they saw when they looked over. Equally, there has also been some acceptance in Europe that flexibility needs to be employed in setting and monitoring fiscal adjustment because austerity policies are growth negative in the short term and that makes fiscal adjustment more difficult.
Another Italian cliff-hanger
The Italian situation is critical to that view. Maybe the Italians have not been taken close enough to the edge of the cliff to make them accept the need to continue with reform or maybe it is just the tribalism of Italian politics which means we will have this uncertainty until there is radical reform to the electoral process.
Either way, my concern is that a political impasse will raise questions about future policy settings in Italy and that may mean that investors require a larger risk premium again.
One of the reasons that the market has not reacted more negatively is that there is a belief the ECB will intervene if sovereign funding becomes a problem. To get to that situation yields would need to rise significantly from current levels. More technically, however, is the question of whether the Outright Money Transactions (OMT) can be activated for a country that cannot deliver on the necessary conditions because it does not have a credible government.
Funding for Italy ahead of Spain, Portugal and Ireland would raise all kinds of moral hazard issues and would be a major concern for German politicians in their election later this year. So any intervention that the ECB could deliver could not be construed as the OMT and thus, if it is something else, there would be significant political questions asked about monetary financing.
Positive electioneering
That would be ratchet up the tensions within the single currency area even higher than we saw last year.
Hopefully the electoral process will evolve to allow Italy to continue its fiscal adjustment and structural reform. The reward will be even lower borrowing costs and a positive cycle of low yields and improving fiscal numbers. The banking system benefits and ultimately so will growth. As I type, there is no government, the message from the election was one of protest against the prevailing economic policy and Italy still has a huge funding requirement for the next couple of years.
I cannot help but conclude the risk is higher spreads versus Germany, even if this does provide a prelude to another round of spread tightening later this year.
The lesson of the euro crisis over the past three years is that problems emerge and it takes a long time for the political solution to come. This time the solution rests almost entirely with Italy itself.
