Karl Smith’s Italian assumption

Karl Smith has a post on Tyler Cowen’s recent remarks about Germany and the Euro. I like Karl’s way of framing the issue: Italy has a primary surplus, and therefore just needs to find new lenders for old ones. There is no real transfer of resources, but a necessary coordination of savers in order for this to work. And the ECB could fulfil that role.

Except, it is not quite true unless you make the important assumption that Italy will have a primary surplus in the future. Who knows that? The cruelty of a currency union is rather obvious, and Italy will struggle, much as Germany did. What is more, the ECB intervention would work against the effort to reform the country and regain competitiveness.

Karl knows all this, of course. It is therefore odd that he seems to deny the risk for the German taxpayer (that ultimately stands behind the ECB) in a lender-of-last-resort operation. And if markets know this risk, and they know that Germany’s public finances are less good than they are commonly portrayed, Karl’s solution may not work in the medium term.

There would have to be some form of collateral, or IMF pressure or the like to supplement the ECB buying Italian debt as I don’t share Karl’s belief in European institutions. But do read Karl’s analysis, it is a useful way to approach the issue.