Fibonacci Would be Proud: Italian Sovereign Debt Math

Analysis: Monti takes off gloves in euro zone fight | Reuters.

The rebirth of the culture in Medieval times was driven by the intellectuals and artists of Italy. In honor of one of the first of these intellectuals, mathematician Fibonacci, let’s show why Italy is going to need a bailout no matter what the official position is.

Let’s say the average interest rate that Italy pays on this debt is 3%. That means that the debt is going to grow by 3% a year if no interest payments are made; hence, just to keep debt levels stable, the economy has to grow at 3% a year. Now, payments are being made constantly so the size of the debt does not grow. (And it hasn’t actually. Italy reached this high debt load 20 years ago and has maintained a relatively consistent 120% debt/gdp ratio.)

What happens when rates rise? Now, we have to raise interest payments to keep the debt load stable. There are two ways to do this. We can either raise taxes to make up the difference or cut other parts of the budget so that we have enough left over to make our interest payments. Both tax increases and cuts to the entitlement programs constituting the lion’s share of the Italian budget will reduce the income of consumers.

They will have less money to spend on goods and services, which reduces economic activity. Taxes decline with economic activity, so now we need to raise taxes and cut spending even more to raise money for these interest payments.

As you can see, once you enter the vicious circle of a debt crisis, there are only two ways out. A de jure default where debts are legally wiped out or a currency devaluation which is a de facto default at the stroke of a pen.

But keep buying Italian and Spanish sovereign debt. The ECB will act, and believe me it will be enough.

 

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