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Italy, ECB Playing with Europe's Future

Italy has two problems: the cost of funding is too high and there is no growth.

What kind of yields on average can Italy afford to pay? Many say below 6 percent, with 5 percent ideal...what would get them there? 1) passing austerity and economic growth measures, 2) getting a technocratic government that can implement reforms, and 3) some aggressive (but not too aggressive) bond buying from the ECB, and you might be able to get below 6 percent.

Just the talk of a deal going through has bought 10-year Italian yields from 7.2 percent to 6.9 percent.

What about the political mess in Italy?

Sure, everyone says the Italians are ungovernable, there's too many parties, 60 governments in 50 years — but this time it may be different. There is a good likelihood many opposition politicians are really just against Berlusconi. Once he is out, and there is some power realignment, the objections to austerity will likely lessen.

As for growth? That's the tough part. Today (Thursday), the EU lowered its 2012 growth forecast for Italy to 0.1 percent from 1.3 percent. 0.1 percent growth, with bond yields going on average, from, say, 4 percent to 7 percent? Not sustainable.

This is where economic reforms come in. Italy must be able to jump-start its economy and improve its low productivity rate. The answers are politically unpalatable but unavoidable: de-regulation, pension reform, and much lower wages. How much lower? I have heard estimates from 10 to 20 percent lower.

That's about what wages in Ireland fell: 20 percent.

Both houses of the Italian parliament should be voting on the package on Friday, or over the weekend.

Of course, the ECB could help Italy out and weaken the euro (lower rates and expand its balance sheet), but don't count on it, and certainly not until an aggressive austerity plan is in place.

As with Greece, the ECB and the EU have clearly seen that the the threat of a funding crisis is the main leverage they have to get real reforms.

Still, most traders feel there is little long-term alternative to the ECB expanding its balance sheet. We have heard from a German (Stark) and a Dutchman (Knot) on the Governing Council of the ECB, both opposing using the ECB as a lender of last resort. But there're 21 other members on the Council. Will they let a core country slip away?

The question may not have to be so drastic: will they let Europe slip into a severe recession? Yes, they are supposed to just target inflation, but does anyone believe that pragmatists will not prevail if a true economic crisis is presented?

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