For a moment last week it seemed like 2010 all over again. The euro crisis has been officially declared dead and buried, but Portugal’s rumblings on top of Greece’s renewed and further financial insecurity certainly made it seem otherwise. Only certain markets seem to care, however, as investor attention no longer seems transfixed by European dysfunction the way it was three years ago.

It’s not just that there are now bigger problems elsewhere (Japan, China, here at home), in Europe so much of what was to be feared has simply been papered. The ECB, in concert with other supranational agencies, bribed markets with the power of “unlimited” (but very unspecific) promises. As a result, local banks went on a national government bond buying spree, effectively disconnecting markets from price signaling of any kind of distress.

In Italy, for example, banks there purchased and added €63 billion in Italian government debt between August 2012 and April 2013 (the latest figures). That is a huge boost to marginal demand for the Italian government and says very little about the state of affairs there or the fundamental creditworthiness of that state.

On the other side of the ledger, the Italian government has been artificially constraining the supply of debt by largely stiffing its own suppliers. After having lost about 1,000 businesses per day in 2012 alone, you would imagine that the Italian government would be urgently looking to finally pay some of the €90-€120 billion in arrears (some, it has been reported, going back to 2008). The country itself doesn’t seem to know exactly how much it owes to its own national businesses, but at least acknowledges there is a huge problem here.

In early April, the new government promised to pay only about €40 billion of the backlog spread out over 2013 and 2014. No definitive plans were announced regarding exactly where Italy would get the money to do so, but there is little doubt it will have to be borrowed at some point. This backlog payment has already been factored into the country’s deficit projections for the next two years – as it is, the Italian government expects to spend 5.3% of GDP just to finance its existing, on-the-books debt load.

There is also little doubt, putting these pieces together, that the new Italian government had hoped for better economic performance to ease its own burdens as well (through increased taxation). The appeal to rosy predictions about the economic future, a feature embedded in this current central banking age, underpinned the plan from the beginning. By pushing the payments out so far, it is clear that they were looking to soften the burden on supply for debt-financing (or, in reality, swapping off-the-books IOU’s to suppliers for on-the-books government bonds).

Now the government is beginning to really feel the pressure to make good on its payment promises (along with cutting taxes). Governing coalition partners are now pushing the current government to start clearing the payments backlog, as well as frontloading that €40 billion in the latter half of 2013 rather than pushing it out into 2014.

As it is, Italian businesses are facing the credit constraints of the very banking system now dedicated (thanks to Draghi’s promise) to almost exclusively financing the government. In reality, the €40 billion is too much to absorb by the “market”, even one as artificially committed to government debt as exists under the ECB “umbrella”. So, Italian businesses, captured already by the longest post-war recession, shutter in record numbers while asset markets largely shrug.

The disconnect couldn’t be more striking. Demand for Italian official debt is artificially boosted by unspecified central bank promises, while supply is constrained by a national government that has taken to not paying its bills in order to refrain from appealing to on-the-books borrowing; trying to avoid a rerun of 2011. Italian businesses are getting it from both ends, but at least markets are calm and the euro crisis is over?

In crochet or sewing, it is very important to make sure that there are no loose ends or “tails” that can later unravel careful work. So knitters and sewers are extremely sensitive to hiding their tails. From the central banking perspective, tails are dangerously similar to crochet – failure to hide the tail, so they believe, can lead to financial unraveling. These financial “tail risks” then, as they are commonly understood, aren’t really tail risks at all but rather statistical misapplications.

If the Italian bond market blows up because banks and other investors suddenly care about the fact the Italian government is so broke it cannot even pay last year’s suppliers, that is not a tail event. It is only the removal of denial; such instability and dysfunction was sewn into the system’s fabric long before reaching the tail.


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