The contagion that has taken Italian government bond yields to euro-era highs sends an unpleasant reminder to eurozone politicians that when it comes to managing sovereign debt crises, perception is all.
Nothing in economic theory or practical analysis can predict when investors will lose confidence in the ability of a government to service its debts. For confidence to return, those same investors have to believe that the rate of economic growth in Italy will exceed the rate of interest on the debt, which implies a reversion to yields close to German levels. Given Italy’s current political mess, it is hardly surprising that the markets are reluctant to give the country the benefit of the doubt.
There are two obvious ways of mitigating the damage. The first is to buy time for Italy and the rest of southern Europe through official purchases of government bonds. The European Central Bank under Jean-Claude Trichet made it clear that it would only engage in bond purchases while holding its nose and on the basis that the purchases would be reversed as soon as possible. The ECB’s new boss Mario Draghi is of the same mind. As Bradford DeLong of the University of California at Berkeley remarks, it is difficult to think of a more self-defeating way to implement a bond purchasing programme. If the ECB has consistently demonstrated a lack of confidence in the very bonds it was buying, why should investors feel any differently?