The big news today is that the ECB will buy Spanish and Italian bonds. Italy is also announcing a balanced budget amendment. The comedy of errors continues. We’ve seen these movies before and we know exactly how they end. Italian austerity will not fix this problem. As we saw in Greece, austerity will only exacerbate their issues by shrinking the economy while ignoring the problem of aggregate debt levels. A balanced budget amendment is not what Italy needs right now. It’s in many ways, no different than the situation the USA is in. As a current account deficit nation, the balanced budget amendment will shrink the public sector while the private sector and foreign sector both act as drags on the economy. This means the Italian economy will shrink which will ultimately make their problems worse in the near-term.
The ECB’s bond buying programs “work” in that they help make a market in government debt. This is like the Fed buying munis. It helps “finance” the government and helps avoid the potential deflation, but these operations are flawed like the Fed’s QE2 in that they are focused on size and not price. Monetary policy is always about price. If the ECB wants this to work they need to establish a ceiling on rates. But as we’ve seen in periphery bonds, the lack of setting a rate actually results in the market controlling the rate. This ECB program will not stop Italian bond yields from soaring when the markets realize that the austerity measures will fail.
Markets love this news. Now, I can’t predict what the short-term market movements are going to be (especially in a market this volatile), but this is not a fix to this environment. We have seen this movie before. It will not work. It is just more flawed policy and I am certain that we will revisit this problem in the near future.