Saving Italy's Bondholders, Not Italy

A blog about business and economics.
Dec. 4 2011 3:42 PM

Who Gains From A Conditional Italian Bailout?

In theory Italy -- with its primary budget surplus but high borrowing costs driven by perceived default risk -- should be well-positioned to benefit from a little old-fashioned collateral. You don't need to put "The Last Supper" up for sale, you just need to mortgage it. If Italy defaults, the lender can reposses various works of art and ancient artifacts so the interest rate is low. And because the interest rate is low, there's no need to default. The lender makes a nice low-risk profit, Italy gets to carry on without getting bossed around by Angela Merkel, and northern European taxpayers aren't left on the hook for anything. Tyler Cowen says this "could never work" because it's unenforceable and "The entire 'tighter sanctions against the fiscal violators' approach, now on the table, encounters exactly this problem."

Let's look at it the other way around. Suppose assistance plus strict conditionality did work. Suppose in other words Italy gets some form of "bailout" -- low-interest loan, temporary transfer payment, ECB interest rate guarantee, whatever -- in exchange for an unbreakable very enforceable promise to never stop running a primary surplus. Who does that help? Ostensibly the idea is that it helps Italy, which is why Italy is agreeing to accept tough enforceable conditionality in exchange for saying yes. But what does it help Italy do? To be sure, Italy avoids default. But why should Italy want to avoid default? The problem with defaulting is that it makes it difficult to borrow money in the future. It'll take you a while before you're ever again able to spend more on programs than you collect in tax revenue. But if Italy were to commit to an enforceable agreement to keep running a primary budget surplus, it will be bearing this cost anyway. Italy -- understood as Italian taxpayers and Italian program beneficiaries -- doesn't benefit at all from the conditional bailout. They'd be better off just defaulting.

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So there's the problem as I see it. The impulse to not want to lend a helping hand absent tough enforceable conditions makes perfect sense, but a deal with really tough enforceable rules wouldn't be worth accepting

Matthew Yglesias is the executive editor of Vox and author of The Rent Is Too Damn High.