Yesterday, in his speech to the parliament, the Italian PM pointed out that markets are wrong because fundamentals are right, and therefore there is not much that can be done. Yet, the situation of the Italian economy cannot be compared with other peripheral countries. In aggregate terms, there are some positive elements : a relatively sound fiscal position despite a huge public debt, a high saving rate, households are little indebted, and the resilience of domestic banks. The main issue for the Italian economy is the lack of economic growth but it is difficult to increase the rate of investment as this is interpreted by markets as a sign of increased debt in future. But above all, it has a huge problem of credibility given the mediocrity of the political class in power.
So why investors are so aggressive in Europe and not the US? Europe has not organised properly its own institutions to curb speculation, starting from regulating the rating agencies. In the US, during the debt crisis, yields on 10 year bonds remained at 2,7% as before. While in Europe, speculation has attacked first the weaker countries, then intermediate countries like Italy and Spain, now France where the spread has reached 1%, and probably next Germany.
In fact, as President Barroso acknowledged ( FT 4 August), it is an attack against the euro, not single countries. This is possible because it is an incomplete construction: a currency without a government being able to coordinate financial and fiscal policies of member States and operate corrective measures as well as solidarity if needed. Strong institutions are therefore necessary, notably a European federal government. This will take time but a step forward could be the emission of eurobonds.
Europe can prevent contagion and curb speculation. The European Financial Stability Fund (EFSF) has intervened to rescue Greece (or more precisely French and German banks), but it does not have sufficient resources to intervene in Spain and Italy. In fact, it should intervene like a European Monetary Fund with increased resources - probably 2-3 thousand billions - to be credible.
Furthermore, part of the problem lies with the fact that the ECB has not taken responsibility in the crisis. The problem is not inflation, but a general risk of deflation. The BCE should intervene and stabilise financial markets . It is the only institution which can do so, like the FED in the US. Panic in markets has led investors to sell Spanish and Italian bonds and buy German bonds, creating a vicious circle: spreads increase in Spain and Italy and austerity measures become more severe. The intervention of a supranational institution may alleviate the pressure of financial markets by buying bonds from States in difficulty. In fact, it has started buying back Irish and Portuguese bonds, and this may be followed by further intervention on Spanish and Italian bonds, which may trigger further institutional changes.
But time is a key factor: European institutions should act quickly and not delay decisions until September. Financial markets never sleep, so we need bold measures to fight speculation in the short term. Moreover, investment policies, especially on EU wide infrastructure networks should be conducted to boost economic growth along with (genuine) structural reforms, in particular on labour markets to create durable jobs as well as exploiting the potential of research and universities to stimulate innovation. But they cannot be achieved under the pressure of markets ; they require fiscal solidarity at the European level with stronger institutions. It is the only effective way to defend States from speculative attacks.