Why We Should All Be Worried About Italy

NEW YORK (BBH FX Strategy) -- I am about to take a two week vacation. I had some time off earlier in the summer, but it was dominated by the concerns of a father of a Little League baseball pitcher. Rather than worrying about mechanics and scoring, I will be contemplating the tragedy that is Europe and I think Italy is the keystone.

Italy is the largest piece of counter-evidence of the German-ECB narrative that the lack of fiscal discipline is at the center of the crisis. Italy's actual budget deficit in 2010 was 4.6% of GDP. The deficit for the euro zone as a whole was 6%. The Dutch reported a 5.4% deficit and France showed a 7% shortfall. Spain's deficit was twice Italy's.

Italy did have a deficit problem, but that was years ago. Those policy errors are part of the reason why Italy has accumulated debt that is approaching 120% of GDP.

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The other part of the reason is that Italian growth has ceased. Its average growth rate over the past decade is less than 0.25%. Euro zone growth has averaged 1.1% over the same period. Moreover, Italy has experienced a steady increase in its labor force as a result of 3 million immigrants (estimates suggest about a third entered the work force). On a per capita basis, Italy has become poorer.

The past deficit plus slow growth has created the mountain of debt. With the wolf knocking on the door and 10-year bond yields pushing above 6% last month, the Italian government responded with new austerity measures in early August.

This did not prove sufficient and the ECB insisted on yet another round of austerity as the condition under which it would buy Italian bonds in the secondary market, over the objections of four ECB members, including Axel Weber's successor at the Bundesbank.

The ECB's bond buying is not sustainable. There appear to be some potential technical problems with neutralizing/sterilizing increasing amounts, but more importantly, the ECB is buying the bonds reluctantly and as a stop-gap measure until the reforms agreed upon on July 21 by the EFSF are approved. That is proving to be more of a problem than many expected as the dispute over Greek collateral threatens to postpone if not outright jeopardize that agreement.