It is a cliché that the big fear for markets is that Italy will suffer a full-blown debt crisis. This leaves an important point unsaid.
Italian government debt is €1.8trn (pdf), or $2.5trn. If it were to default on 50% of this - worse, I suspect than most people‘s worst-case scenario - there’d be a loss of wealth of €0.9trn or $1.25trn.
This is not much. Two things tell us so.
First, the marginal propensity to consume out of financial wealth in the euro area is around 1.4c per euro. This implies that if Italian debt were held by euro area households, such a loss would lead to a drop in consumption of 0.014 x 0.9 = €0.126trn. This is 0.14 per cent of euro area GDP. Which is barely significant*.
Secondly, economies have suffered far larger losses than this and survived easily. Between March 2000 and October 2001, the Wilshire 5000 index fell from 14750 to under 9900. Holders of US shares therefore lost $4.9trn - four times that loss on Italian debt. But that led to only the mildest of recessions.
Why then are relatively small - and theoretically manageable - losses so frightening the markets?
It’s not because the problem won’t be confined merely to Italy. Throw in a 50% write-off of Spanish and Portuguese debt as well, and we still have a loss of only €1.3trn ($1.8trn).
One possibility is that in 2000 investors regarded high share prices as “house money” - the result of good luck - and so were more relaxed about its disappearance than they would have been had it been the “real” wealth that is government bonds.
This, though, might not be all the story. Expectations for equity returns in 2000-01 - among both households and companies - were high, so the market’s fall came as a shock. That should have hit consumer spending and capital spending.
Instead, there’s another reason to fear. There’s a massive difference between US equities in 2000 and Italian government debt. US shares were held mostly in small sums by millions of investors. The losses were thus small and manageable for most sensible investors, and even where they weren’t, the losers were not strategically significant for the economy. Italian debt, however, is heavily held by a few banks and their losses - unlike the larger losses on US shares - threaten to have multiplier effects via a reduction in bank lending.
This seems obvious. But it represents a (further?) rejection of the neoliberal pre-crash orthodoxy. This said that the virtue of freeish financial markets was that they allowed risk to be split up and borne by those best able to bear it. But the euro debt crisis shows this not to be the case. If government debt holdings were dispersed, the crisis would be trivial. But they are not, so it isn’t.
What we have, then, is not a government debt crisis at all. Instead, we have a crisis of risk-bearing. The problem is that risk is borne by not by markets but is excessively concentrated in systemically important financial institutions (SIFIs). Which poses the question raised by Thomas Hoenig: do SIFIs have a future?
Ideally, the answer would be: no. The problem is, though, that European policy-makers are not even asking the question.
* Things aren’t quite so simple. A Italian default could actually boost the wealth of Italian tax-payers (there are some) by reducing future interest payments. This might, however, be offset by higher interest rates on the remaining debt as investors require compensation for the risk of further default. I’m ignoring this complication.