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Belmont Club

Rorke’s Drift

July 10th, 2011 - 5:36 pm

European officials prepared to discuss the sudden rise in Italy’s interest rates on the bond market. The New York Times reported that “fears mounted that Italy could become a victim of the debt crisis even as discussions stalled over a second bailout for Greece.”

For Italy, the cost of financing its debt rose at the end of the week, though nowhere near the levels faced by Greece. The spread between the yield on the Italian 10-year bond and the German equivalent widened on Friday to 2.36 percentage points, the most since the introduction of the euro.

The Daily Telegraph says fears of contagion “were stoked by dramatic falls in Italian stocks on Friday. Shares were dragged down by Italy’s banks, which along with other European banks will learn the results of “stress tests” later this week. Shares in Unicredit Spa, Italy’s biggest bank, fell almost 8pc on Friday.

“The EU is definitely worried about what happened on Friday. Key people have suddenly realised that this [contagion] is going to hit big economies and they have little defence,” said one observer. … So far, EU officials have been treating the debt crisis as a liquidity issue that can be dealt with using bail-outs. However, if economies the size of Italy get caught up in it, then broader structural changes to the eurozone are likely to be required.

The EU’s decision to defend Greece had unintended consequences for the rest of the other members of the currency union. Principally it showed up the weaknesses in the system as a whole thereby creating a crisis of confidence that was wider than Greece. One parallel in military history were the Third Fleets attacks on Mindanao in September of 1944. The weakness of Japanese air resistance in the Southern Philippines precipitated a decision to bypass Mindanao altogether and go direct for the Central Visayas. In that instance, the weakness in a local position demonstrated the feebleness of the whole. In the case of Europe, the rotteness of Greece has translated directly to doubts about the soundness of Italy’s position.

In retrospect, the EU might have been bettered served abandoning Greece in order to shorten the financial defense lines around Italy. By demonstrating to the bondholders that it could not defend Greece they simultaneously established that they could not defend Italy. The Economist described how “contagion” could leapfrog one country and go straight to another.

The hard numbers alone thus suggest that a Greek default would do little lasting harm to the rest of Europe’s financial system. What is more worrying for Europe’s policymakers is the thought that Greece’s affliction would spread not just to foreign banks but to foreign governments. … First and second in line would be the next-wobbliest members of the euro zone: Ireland, whose government has debts of around €150 billion, and Portugal, which owes €160 billion. … However, if contagion were to spread to Spain or Italy, and banks had to accept losses on their governments’ bonds, the sums would look grim even for some banks outside the affected countries. Italy owes €1.8 trillion, or 120% of a far bigger GDP than Greece’s, Ireland’s or Portugal’s.

The collateral consequence of not being able to defend indefensible Greece was to open the road to Italy. Unchecked, the contagion may now leapfrog Portugal and Ireland altogether and go straight to Rome. For those who want another military analogy where this happened there is the British defeat at Isandlwana in which the British made the cardinal mistake of pushing their front line too far forward. Not only did it render ammunition resupply problematic, it divided Lord Chelmsford’s columns in such a way that the Zulu impis could surround and destroy the British units in detail. By contrast the much smaller British force at Rorke’s Drift survived because John Chard and Gonville Bromhead concentrated their available forces around a feasibly defensible position. The EU, in trying to defend everything may have condemned itself to defending nothing. The problem with double-down strategies is that you may lose your shirt and not just your socks. It may be an expensive lesson for Brussels, provided they are capable of learning anything.

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