Things worsened in the Eurozone this week, as the graph at left vividly demonstrates (compare my post of Nov. 5, 2011, less than three weeks ago). The Italian 10 year bond yield now seems firmly over 7 percent (it closed today at 7.26), an unsustainable level. Today, Italy auctioned off three year bonds at a yield of 8.13 percent--and the auction price reflects market demand from real investors because the ECB can only buy on the secondary market. Rome now pays more to issue short term debt than Greece. These rates of interest mean that interest paid by Italy to roll-over its debt will explode and wipe-out any gains from any new austerity initiatives. Italy's budget deficit is now destined to expand, not decrease, as it faces a vicious cycle of spending cuts leading to lower growth leading to higher deficits leading to more not less interest expense. Austerity now failed in Italy just as it failed in Greece. I noted the failure of Greek austerity on Sept. 2, 2011. So, Italy now appears in train-wreck mode.
Things similarly darkened in Spain this week. As the chart at right shows, Spanish 10 year bonds now yield 6.7 percent. Spain too now pays more to rollover its debt than Greece and the market issued a negative verdict on Spanish austerity this week:
"Bond market investors have given Spain no relief despite the election victory on Sunday of Mariano Rajoy, the centre-right Popular party leader who has pledged further austerity and economic reforms once he becomes prime minister in December."
Meanwhile, the contagion from the debt problems in southern Europe has now gone viral. S&P downgraded Belgium today due to political instability and the lack of growth throughout the Eurozone. French debt yields are now surging with the expectation of a imminent downgrade. Hungary solicited an IMF bailout and was downgraded to junk yesterday. Fitch downgraded Portugal to junk. And, perhaps most ominously, Germany (yes, Germany), suffered a failed bond auction, and the Bundesbank had to step in and buy 39 percent of the bonds offered. Suddenly, pundits are discussing the possibility of a German downgrade.
A fairly horrendous week, by any standard. The market reaction confirms this. The Euro sits at a seven week low. The European stock market now has lost over 30 percent in the last six months. Over the same period, US financials are down 25 percent. Over the last two weeks, the Dow is down 7.6 percent and the S&P 500 is down 7.9 percent in just the last seven sessions. Due to the exposure of our banks to Eurozone debt and to European banks (almost $ 2 trillion), the US cannot survive a European collapse unscathed. Think MF Global times 100.
Over the next few weeks I will explain how we got into this mess, and how the Eurozone cratered. For Europe the story is excess current account imbalances and the failure of austerity as a means of addressing a debt crisis. For the US it boils down to the failure of Dodd-Frank to change any of the following:
1) Derivatives deregulation that allowed global financial institutions to manipulate the system for their personal profit;
2) Corporate governance law and regulation that continues to permit CEOs to impose huge risks upon their firms in pursuit of short term bonuses;
3) The failure to limit excess leverage in the financial sector and thus excess risk;
4) The failure to end Too-Big-to-Fail which leads to excess risk in the financial sector and excess debt in the government sector, while limiting growth;
5) The failure to institutionalize fiscal policy in an economically rational way to limit excess debt while maximizing growth.