01/08/2012 10:46 pm ET Updated Mar 09, 2012

Can Italy Derail the U.S. Recovery?

As the United States see its unemployment rate drop from 9.5 percent to 8.5 percent having created approximately 1.6 million part- and full-time jobs in 2011, a slow but steady growth path seems to open up for 2012 with a forecast of 2.5-3 percent growth for the country as well as for the global economy. Its exorbitant indebtedness would have been deadly if investors were not considering the United States as the strongest credit in the world, and clearly continue to purchase U.S. Treasuries at record low interest rates.

With China and India still expected to grow by 8 and 6 percent respectively, the threat should not come from emerging markets.

While it is too early to be sure that such forecasts will be effective, we need to look at what could derail this scenario. The biggest concern is Europe.

How did the situation evolve?

Greece is virtually bankrupt and its bonds currently yield at 40 percent for ten years (from 10 percent a year ago). The October decision to obtain a 50 percent haircut from banks has not been implemented yet.
Portugal and Ireland borrowed 3 billion euros from the European Fund for Financial Stability last week. A drop in the ocean.
Spain is now a better credit than Italy and can access ten year markets at 5.7 percent, a remarkable result considering its 23 percent unemployment.

The problem is Italy: with 1.8 trillion euros of outstanding debt, it will need to borrow this year alone 440 billion euros. Its 10-year bonds now yield over 7 percent. It was below 5 percent three months ago. The huge amount of debt refinancing represents one-quarter of the Eurozone needs. As Prime Minister Monti said today, no country can fight debt alone.

Unable to purchase more Eurozone bonds, the European Central Bank (ECB) resorted to lending 150 billion euros to the International Monetary Fund who is competent for lending to countries in difficulty. Since there is no Euro-Treasury, there is no lender of last resort.

More recently, the ECB auctioned almost 500 billion of 3-year loans to European banks for a 1 percent interest rate. This Christmas gift ended up in the balance sheets of the Italian banks for 110 billion euros, none of which was used to purchase Italian bonds.

Last but not least, the largest Italian bank, Unicredit, is fighting to launch a capital increase at a 40 percent discount to its stock price. A desperate attempt to rebuild its balance sheet.

This situation has been known for a long time. For the last 5 years, Berlusconi's Italy was well above the European limits of indebtedness and budget deficit. Nobody challenged the Cavaliere. Three months ago, a rescheduling of the Italian debt maturing in 2012 and 2013 would have been possible at 5 percent, a sustainable rate for the country's refinancing and a sharp reduction of its need to borrow on the market. The European authorities have taken no preventive initiative.

It is now urgent to create a crisis steering group that would include the IMF, the Eurozone and Italy and monitor the situation.

A default of Italy would be unbearable. There is no money available to bail out Italy. Furthermore, President Sarkozy has increased France's borrowing by 600 billion euros, up 55 percent in less than five years. France will soon reach the level of indebtedness of Italy. The combined indebtedness of Spain, Italy and France amounts to 3.5 trillion euros ($ 4.5 trillion).

A default of Italy would trigger a European bloodbath and a world crisis compared to which the 2008 crisis would look as a blip. In the meantime, the European leaders will meet to discuss an ill-fated tax on financial transactions!

Is there a captain on the plane?