October 4, 2005

Italy and the ECB

Is this all as loony as it looks? Maybe not. “One of the points of monetary union was to dampen volatility, encourage fiscal responsibility and reduce borrowing costs, and in that it has succeeded,” observes Laurent Fransolet, head of European fixed-income strategy at Barclays Capital. But there are limits.

The problem now is that we seem to have the worst of both worlds. Bond yields do not reflect real risks, so market discipline isn’t doing its job. Neither are the Eurocrats. The EU’s fiscal requirements for euro members are being flouted left, right and centre; Italy will be the first real test of whether even the new, watered-down version of them will prevail. So making tough decisions to reduce structural deficits and keep debt from taking off falls squarely on the shoulders of national governments. And these are not very robust.

The rewards for making difficult adjustments to get into monetary union were obvious: lower borrowing costs, access to a bigger market. The rewards for making them now appear to be recession and getting chucked out of office. A leader with a strong mandate would find it hard. The broad coalitions that dominate the landscape in both Italy and Germany will find it all but impossible.


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