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MARSH ON MONDAY
Will Italy have to turn to gold?
Commentary: Metal poses unattractive fallback position for troubled economy
By
David Marsh, MarketWatch
Last update: 12:01 a.m. EST March 2, 2009
LONDON (MarketWatch) -- A passionate debate has broken out in Europe on the pros and cons of modifying the so-called "no-bailout" clause in the Maastricht Treaty that prohibits states within the economic and monetary union from propping each other up through reciprocal balance of payments support.
German Finance Minister Peer Steinbrück is under pressure from widening yield spreads on euro area government bonds and the perception that Eastern Europe, in particular, could bring disarray to the union.
In view of the widespread feeling that only Germany is strong enough to help the disadvantaged states in Europe, Steinbrück has been toying in public with the idea that the Germans may have no alternative but to help out more troubled states. This is partly a question of self-interest: Germany has greatly profited from its increasing competitive position on euro area export markets since 1999.
The problem is that the worldwide downturn has hit Germany harder than many other countries precisely because of a sharp decline in the exports on which it has traditionally built its strength. Advocates of economic stability complain that changing the no-bailout clause would completely undermine the EMU's anti-inflationary foundations. Former Bundesbank president Karl Otto Pöhl said it would "open a Pandora's box" and throw the entire future of the project into doubt.
The principal weak link in the Euro chain, as has been well known for many years, is Italy. It's a country of huge cultural and political attractiveness but one whose already weak economy has been further hit by an unprecedented decline in competitiveness since it joined the Euro 10 years ago.
Italy this year faces a severe GDP decline, an expanding current account deficit and widening risk premiums on government bonds. If Italy stays in the euro area on present policies -- and to think the unthinkable, if it were to leave -- damage to the EMU would be severe. How can Italy be stabilized without international political and economic conflagration?
Wages won't catch up
It is impossible that Italian wages and price will adjust sufficiently in the next 12 to 24 months to close the alarming gap in competitiveness between stronger and weaker euro members.
Don't expect export-orientated German companies to commit collective suicide by granting nominal wage rises to their workers of the order of 8 to 10% for the next couple of years -- what's needed to allow Italy to catch up. Germany is beset by falling prices and demand in Europe and the rest of the world.
Unless risk premiums on Italian debt grow further, some form of special Italian financing action is needed. In essence, Italy needs secure financing for the next few years to allow the current account deficit and the gap in wages and prices to close smoothly rather than through the brute force of the markets.
Action by the German federal government to grant a formal guarantee for the Italian national debt can be ruled out for political and legal reasons. It would be tantamount to declaring civil war in Germany, and it would not go down well in Italy, because such a strong affirmation of solidarity would not come without stringent conditions.
Avoiding manipulation
One must not forget that one of the reasons why Italy favored the EMU under Prime Minister Giulio Andreotti in 1990-91 was to avoid being bossed around by a supposedly more dominant reunified Germany.
Setting up a European debt agency to issue common bonds for euro area countries also seems highly unlikely. The idea has been suggested frequently by bond dealing associations to boost European government liquidity, and picked up recently by Jean-Claude Juncker, the Luxembourg prime minister and president of the Euro-Group of finance ministers, as well as George Soros. But there is no political consensus backing such a scheme, and it would also be costly and time-consuming to set it up.
Present EU mechanisms allow for balance of payment credits for countries in trouble, perhaps accompanied by loans from the International Monetary Fund. But these steps would also take time to enact and might be bogged down by bureaucratic decision-making procedures.
One inconvenience is that IMF programs come with strings attached -- usually involving a currency devaluation that is impossible now that Italy has no currency left to devalue.
Italy needs principally to buy time and shore up confidence so that shorter-term liquidity problems are resolved, government policy has a chance to adapt to the new circumstances and interest rates on Italian credit can fall to more reasonable levels.
One theoretically propitious way forward is through specific bilateral assistance. Reflecting Germany's significant de facto stake in Italy's future, the Bundesbank could grant the Banca d'Italia a significant dollar-denominated bridging loan tied to part of Italy's massive gold reserves -- 2,450 tons with a current value of around $75 billion.
Precedent
There is a precedent. In 1974, German Chancellor Helmut Schmidt, together with his close friend Bundesbank President Karl Klasen, pushed through a gold-backed loan for Italy of $2 billion. It was to ward off balance of payments difficulties after the Italians left Europe's currency stabilization scheme, known as the "Snake."
Showing the limits of the Bundesbank's fabled independence, Schmidt and Klasen cooked up the idea without consulting the decision-making Bundesbank council. There are several large question marks, though. In today's more rigorous climate, sidestepping such formal mechanism would be unthinkable.
Even if Angela Merkel's government decided such a rescue plan was fundamentally sound, pushing it through today's decision-making mechanisms, including the European Central Bank, would be very difficult.
In 1974, the loan was used to support a country that was on the way to improving competitiveness through floating -- not the case today. Additionally, would mobilizing part of Italy's gold reserves, even at close to $1,000 an ounce, really make much difference if there were a full-scale speculative attack on Italian state paper?
So Italy's gold probably will remain deep down in the vaults, unused but not unloved -- ready for the day when, ultimately, it's needed.
For news and information on David Marsh's latest book "The Euro - The Politics of the New Global Currency" (Yale University Press - German edition: "Der Euro - Die geheime Geschichte der neuen Weltwahrung" please go to http://www.londonandoxford.com/The_Euro/The_Euro.htm
David Marsh is chairman of London and Oxford Capital Markets. The Marsh on Monday column appears in German in the newspaper Handelsblatt.
