Does Italy Just Need A Little Breathing Room? : Planet Money Or is the country bound to default sooner or later? It's an important question for the U.S. economy.
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Does Italy Just Need A Little Breathing Room?

Is Italy fundamentally unable to pay off its debts and bound to default sooner or later? Or does the country just need a little breathing room to get its act together?

This is a key question, and not only for Europe. Italy's economy (and outstanding debt) is so much bigger than those of the other troubled euro-zone countries, and its banks are so much more interconnected with U.S. banks, that a real crisis in Italy would likely cause big economic ripples in the U.S.

Jess Jiang/NPR
EU debt outstanding
Jess Jiang/NPR

So today's news that the European Central Bank started buying Italian and Spanish government bonds is a big deal.

The ECB's intervention suggests the central bank thinks Italy is ultimately good for its debts, and just needs a little breathing room. (In the language of finance, Italy has a liquidity problem, not a solvency problem.)

Of course, for most of the past year, official Europe was engaged in the fiction that Greece had a liquidity problem but not a solvency problem. That was the rationale for Europe's bailout of Greece, which initially took the form of just lending Greece even more money.

Europe finally gave up on that fiction last month. Officials finally came up with a plan that recognized Greece could never pay off all of its debts, and that pushed investors who bought Greek bonds to take a loss.

Italy, for its part, has the second-highest debt-to-GDP ratio in the euro zone, after Greece.

Still, there are reasons to think that Italy — unlike Greece, and despite the size of its debt — may indeed be able to pay off its debts without wrecking its economy.

As PIMCO's Andrew Balls pointed out on Friday's podcast, Italy's annual deficits are quite small. When you exclude interest payments on its national debt, the government actually takes in more money than it spends every year. Italy didn't have a housing bubble and its banks are in decent shape, Balls said.

The main problem for Italy, Balls and others have argued, is contagion: Investors get nervous about European debt, and that nervousness spreads from countries that are truly insolvent (Greece, Ireland) to those that are in better shape (Italy).

That nervousness leads investors to demand higher interest rates from the likes of Italy. The higher interest rates drive up Italy's borrowing costs, which make the debt burden even worse.

If Balls and the ECB are right, the ECB's decision to buy Italian bonds — which drove interest rates on Italian bonds way down today — could buy Italy the time it needs to get its act together, pay down its debt and avoid default.

Here's how Paul Krugman put it in a post yesterday evening:

So there is a reasonable case that what we're seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that's exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn't needed. It's certainly worth a try.