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[Tyrone Slothrop]

Greg Ip:

Understanding the euro crisis: ASK any pundit why Italy is in crisis and they will mention some combination of Silvio Berlusconi, a towering national debt, and a moribund economy.... But these factors are not the root cause of the crisis and as long as Europeans behave as if they are, a resolution will elude them.

As recently as 2009 Italy’s debt was 97% of GDP (it’s 100% now) and its deficit was 5% (compared to 4% this year, according to the IMF). Yet that year Italy could borrow at 4%, not much more than Germany, whereas now it must borrow at 6%-7%, triple what Germany pays. What changed is not Italy’s political or economic fundamentals but how investors perceive Italian debt. For most of the euro era, investors considered euro-zone sovereign bonds risk free.... Risk-free can only apply to the debt of country that controls the currency in which it borrows. A holder of its bond knows he can always sell it to someone else, in the last resort the central bank. As Chris Sims of Princeton points out, such bonds may have inflation risk but not counterparty risk.

That has never been true of a euro-zone member country, but investors happily ignored the fact....

A staggering amount of debt must now migrate from the portfolios of investors who want only risk-free debt to those of investors comfortable treating it as credit. That is why yields on Greek, Portuguese and now Italian bonds have shown only fleeting responses to multiple bail-outs, austerity programmes, and rounds of buying by the European Central Bank. Investors have treated the dip in yields that follow each announcement as an opportunity to lighten up. In the case of Greece, the volume of debt is small enough to find a new home on the balance sheets of the official sector (the ECB and eventually the European Financial Stability Facility). Italy is an entirely different matter....

It has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can.... It is hard to know what Italy can do to change this dynamic.... Italy’s new borrowing needs are small, given its modest deficit. But its refinancing needs are, massive.... [T]he European Central Bank... could reward a serious budget plan by Italy’s new government with a commitment to keeping Italy solvent via far more aggressive bond purchases.... Whereas the Bank of England can be compelled, if need be, by Parliament to be lender of last resort, the ECB does so only by choice....

Italian bonds do not have to be restored to risk-free status, they only need their yields dragged low enough for Italy to remain solvent. Whether outside investors have the appetite to absorb all that paper at sufficiently low yields is unknown. In the meantime politicians repeatedly undermine the market confidence necessary for that to happen....

The worry, then, is that as each new turn of the austerity screws fails to produce the hoped for relief in the markets, more austerity will be prescribed, until the Italian political system rebels, making default and exit from the euro unavoidable. Is there an alternative? Our leader this week concludes: