Both the U.S. and Italy (NYSE:EWI) have gained lots of media attention as the two countries head for possible default. However, the U.S.’s problems are largely of its own making and default could simply be avoided by lawmakers coming to an agreement in debt discussions, while Italy’s problems are far less tractable, as the country faces default because of weak economic growth and the Euro-zone has been unable to solve its peripheral debt crisis.
One need only look at the bond yields for the two countries to recognize a fundamental difference in the problems they are facing: while Italy’s bond yields are well above their highest levels since the Euro was launched in 1999, U.S. bond yields are down to their lowest levels so far this year, implying that there is no real market fear of U.S. default while an Italian default seems significantly more likely.
Both Italy’s high public debt ratio (around 120% of GDP) and its weak rate of GDP growth (only 0.6% per annum since the nation joined the euro) are to blame for Italy’s fragile state. Combine that with a very low inflation rate set by the European Central Bank, and all it would take is a minor increase in interest rates over the medium-term for the debt ratio rise in perpetuity. Because of this possibility, bond yields are skyrocketing, and higher bond yields reduce prospects for future growth in a self-perpetuating cycle. If the country had a central bank that could prevent default by printing more money, then the markets would be, like ours, more worried about inflation.
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One need only compare Italy to the U.K. (NYSE:EWU) in order to see the importance of a central bank in preventing default, and to understand that any U.S. default would only be the result of a failure by policymakers to act, and not the unavoidable consequence of our high debt-to-GDP ratio. In the U.K., currency has been devalued and inflation has risen, but bond yields have remained low because because the independent central bank’s ability to print new money whenever necessary protects against any default risk.