While our politicians are looking for the least painless solution for resolve the sovereign debt crisis, it is worth recalling what happened in 1926. Italy had emerged from the First World War with an enormous public debt which, at the beginning of the 120s, exceeded XNUMX percent of the gross domestic product which today is the object of so much attention from the of the financial markets. In addition, the composition of the public debt was strongly unbalanced towards short-term debt (at the time called floating debt and given by the sum of advances from the Bank of Italy to the state, government bills and treasury bills).
In 1924, the fascist state issued a 25-year bond, at 4,75%, with the aim of enticing BOT holders to convert. The operation was unsuccessful. With a weak lira in the foreign exchange markets and growing fears of a possible debt consolidation (today we would call it restructuring), maturities bills were converted into currency. The level of the debt and its short average duration would have prevented a monetary stabilization that Benito Mussolini would later announce in his speech in Pesaro on August 18, 1926. On November 6, 1926, a decree law authorized the issue of the so-called Littorio loan which required the conversion into consolidated securities (securities without expiry such as the English consuls) of ordinary bonds, five-year bonds and seven-year bonds for a value of 20,5 billion lire which represented over a fifth of the public debt.
The consolidation imparted a large drain on liquidity which, at the end of December 1927, allowed the government to restore Quota 90 (actually 92,46 lire to the pound) and gold convertibility. Italy paid for the return to the gold standard to the old parities with deflation and high real interest rates (Note that high interest rates penalise, among others, the old holders of public bonds who sell on the secondary market but do not influence the cost of debt on consolidation that the State pays). On the other hand, the public debt structure improved markedly. In addition, the decree on the Littorio loan was followed by a second decree which abolished the autonomous section of the Consortium and created the Istituto di Liquidazione, both aimed at relieving the State of the cost of the bailouts.1 What lessons can we draw from this episode?
I state that the judgment of history on consolidation tends to be influenced by the negative assessment that economists and historians have given, in the wake of the thought of John Maynard Keynes (in particular The Economic Consequences of Mr. Churchill, 1925), on the stubbornness of the leadership of the era to restore the gold standard to pre-war parity. This policy entailed high economic and social costs associated with the effects of deflation in a world where prices and wages are relatively rigid. But apart from this, it must be recognized that the forced consolidation of 1926 represented a chapter in the recovery of the Italian public debt, whose main contribution was given by the settlement of war debts begun in 1925 and then completed by the Hoover moratorium of 1931.
Today's Italy shares with the Italy of 1926 the burden of a massive public debt; otherwise there are substantial differences. Italy in 1926 was looking for monetary stability which it intended to achieve with a return to the gold standard. However, with its own central bank, even if it had just been set up, the Italian state had unconditional access to a lender of last resort. If the gold standard constraint proved to be too strict, the government could abandon fixed exchange rates and resort to its central bank for the financing of budget deficits (as it did in the XNUMXs). Finally, a large part of the public debt was owed to foreign states which, as a result of the war, were willing to make concessions on this debt.
Today's Italy, on the other hand, operates in an area characterized by permanently fixed exchange rates (the Euro-area) and with a central bank (ECB) which represents the interests not only of Italy but of a large and heterogeneous community of sovereign states. The ECB plays the role of lender of last resort to the banking system: it did during the subprime crisis and it continues to do so today. However, it is not authorized to do so, by statute, with regard to the member states. To regain this role, Italy would have to either convince the other euro-area partners to change the statute or exit the euro-area and re-introduce a national currency. The first option finds the strong opposition of some member states of the Euro-area, Germany in the first place; the second is hampered by a high exit cost. Finally, even if a substantial proportion (45 percent) of Italy's public debt is held abroad, unlike in 1926 today's creditors are not willing to make concessions.
A consolidation of the Italian public debt could represent a valid alternative to consolidation solutions that require a strong political commitment from the "strong" partners of the Euro-area, a commitment that clashes with an electorate reticent towards a political-fiscal integration of the euro-area; this applies as much to the Eurobond proposal as to a strengthening of the bailout fund or an accommodating ECB. The advantage of a consolidation is that Italy would decide and not other countries to impose recovery plans on it. One of the many variants of consolidation could be a forced conversion of all bonds under 10 years into XNUMX-year Treasury bills issued either with a fixed coupon that does not exceed the ECB's target inflation rate or, even better, with a variable coupon that fully or partially adjusts to the ex-post rate of inflation.
Regardless of the technical formula adopted, consolidation must satisfy two objectives: the first is to free economic policy from the frenzy of debt renewal for a period of time long enough to complete a recovery; the second is to lower the real interest rate on public debt to values close to zero. A consolidation entails a tight and immediate budget constraint for the Treasury. No longer having the reputation to issue bonds, the government must inevitably limit spending flows within revenue flows (apart from bank loans). This also took place after 1926 when the state was unable to issue BOTs for several years.
Considering the degree of historical forgetfulness of the financial markets towards states that have restructured their debts, the imposition of a strong budget constraint and the absence of new supply flows of public bonds would help to restore confidence in Italian government bonds and to reduce its spread against the Bund relatively quickly, probably within five years. We must not delude ourselves that the operation is free of charge; if it were there would be no debate. Holders of government bonds, both in Italy and abroad, would incur a loss of capital if they decided to sell them on the secondary market.
The state would lose its ability to finance itself on the financial markets during the period of historical forgetfulness. The economy would suffer from high interest rates resulting from the consolidation until the markets mature the conviction that the Italian state is on the right path to a lasting recovery of its debt. Concerning the banks, the Achilles heel of both the subprime and sovereign debt crises, consolidation should not seriously damage their balance sheets. Banks that could use government bonds at zero cost of capital and without accusing balance sheet losses, as long as the regulator allows them to place the bonds in the holding period category.
The market, on the other hand, would penalize them for not accounting according to the holding period rules. In summary, consolidation has its costs. But these must be evaluated in relation to the costs of the alternatives. The possible solutions are either to act on stocks (debt) or on flows (budget deficit). The "strong" countries of the Euro-area, failing to agree on a serious program on stocks, "impose" drastic solutions on flows which penalize growth and the prospects for a recovery of stocks. A risk premium of 400 basis points weighs on the Italian one today, and the economy is not growing. Debt consolidation should be assessed against the prospects that can be glimpsed today and not in terms of an unlikely savior of the country.
Read Andrea Monorchio's proposal, former State Accountant General
