An artist's depiction of Rome burning - danielucas.com  With the European sovereign debt crisis escalating dramatically, after Italian bond yields hit record highs on Wednesday and France’s bond spread over German bunds continues to widen, the possibility that the EU will fail to find a solution and will be forced to break up is now very real.  Nouriel Roubini, the famed NYU economist dubbed Dr. Doom for his ultra-bearish predictions, argues that without the ECB engaging in QE (drop rates down to zero and massively purchase bonds) and a strong stimulus program from Germany, the European Union will not survive.  Italian bond markets might have passed the point of no return on Wednesday, when yields on 10-year sovereigns traded around 7.5. According to High Frequency Economics, Italian bond price action erased about €50 billion of wealth on Wednesday. The following day, the Italian Treasury placed €5 billion in 1-year bonds at a rate of 6.087%, helping to materialize a clear yield curve inversion.  While it appears possible that Italy may be able to save itself, Roubini doesn’t believe so. According to the FT’s James Mackintosh, Rome’s finances can be sustained for about a year at current, and slightly higher rates.  On the surface, the problem is investor confidence and political willingness from France, Germany, and the ECB to bail the Italians out, a move that seems more tenable now that PM Silvio Berlusconi has agreed to resign. But on a fundamental level, the problem is much deeper than it seems. Roubini thinks the problem is so bad that it will lead to a debt restructuring of Italy’s massive €1.9 trillion in sovereign liabilities, along with a return to Italy’s former currency. In other words, the execution of a dreaded euro break up.  The argument appears to have been that Italy, and Spain, face a problem of liquidity, unlike their battered fellow PIIGS which also face a problem of solvency. Italy does have a primary surplus and, even though unproductive, counts with a working economy. But, Roubini argues, once an illiquid but solvent country loses market credibility, and is practically pushed out of global markets by widening spreads, its debt dynamic becomes unsustainable and the country itself becomes insolvent.  Italy is indeed nearing the point where it will lose market access, as Barclays’ analysts suggest. As the France, Germany, and the ECB put pressure on Italy to get its reforms going before providing support, bond yields reach a level “which might trigger more and more capitulation selling by traditional investors in sovereign bonds. The latter could well lead to an erosion of the investor base in Italian sovereign debt,” which indeed could keep yields from ever falling to sustainable levels.  At the same time, rising Italian bond yields hurt Italy’s creditors. Major French and German banks, along with big names in the U.S. like Morgan Stanley, Goldman Sachs, JPMorgan, and Jefferies have exposures to European sovereign debt and have paid the consequences in terms of share prices. MF Global couldn’t take it and was forced into bankruptcy. High Frequency economics suggests that banking needs for capital are in the €1.4 to €2.5 trillion. And that doesn’t factor in major U.S. company sales exposure to Europe, with firms like GM, Ford, McDonald’s and even GE greatly exposed.  Bailout money is greatly needed, then, with Italy seemingly looking for a lender of last resort to help it pay its debts and banks in trouble due to their exposures. At the same time, austerity and reform have a negative impact on aggregate demand and supply, Roubini notes, and that is particularly worrisome given Italy, and Europe’s already slowing output. Italy would need to maintain at least a 5% primary surplus to finance its debt, Roubini believes.  The only solution, then, is a restructuring of debt, “that will cause significant damage and losses to creditors in Italy and abroad” and won’t even restore growth and competitiveness. “That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labor costs.” Roubini explains:  So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts.  The only way to stop the upcoming disaster, according to Roubini, is quantitative easing. The ECB would have to drop interest rates to zero, effectively helping to depreciate the currency, and begin massively buying up Italian and peripheral debt. The euro would fall to parity with the dollar, Roubini says, and Germany and other “core” countries would have to implement fiscal stimulus plans to compensate for the fall in aggregate demand caused by austerity in peripheral nations.  It’s clear why they call him Dr. Doom.
Nouriel Roubini, Dr. Doom, believes Europe is in serious trouble as Italy is at risk of becoming illiquid and insolvent, losing market access, rendering it unable to service its debt and grow, forcing an EU exit.