Greece is in default and Ireland and Portugal are in limbo with the market pricing in a Greek outcome in both economies. However, the situation has changed in Spain and Italy and on this measure alone, the ECB’s LTRO has been successful.

Italian and Spanish bond curves have consequently steepened significantly as short-term yields have come down. The price of this has obviously been a significant increase in the ECB’s balance sheet as well as a sizable portion of risk in the Italian and Spanish banking sector effectively being stored at the ECB in exchange for reserve assets (deposits) and domestic government securities.

This is a price the ECB (and the EU/Germany) have been willing to pay due to the insurmountable challenge of bailing out Spain and Italy or even one of them in isolation. Still, even as funding risks have abated, the approach towards the need for ongoing cuts in public deficits have been quite different in Spain and Italy.

In Spain, the EU and markets had to contend with a significant overshoot of the 2011 deficit which, according to the budget minister Cristóbal Montoro, came in at 8.8% of GDP. This is significantly higher than the 6% set out as a jointly agreed target between the EU and Spain in the beginning. This also means that if the 2012 target of 4.4% of GDP is to be met, the new prime minister Mariano Rajoy will have to slice the deficit exactly in half.

Not many believe this is possible and, incidentally, neither do Rajoy and the centre-right People’s Party (PP).  As a result, Rajoy and his government has kicked back against the previously agreed target and set a new milder target at 5.8%. The response so far from the EU has been to stand firm on the previous target and in the case of the fiscal compact coming into play, there is scope for “automatic” sanctions against Spain sooner rather than later. Obviously, this is not likely at this juncture as the risk of pushing Spain back into a situation in which its yield curve inverts is not something the EU wants to contemplate.

One of the main problems in Spain is that regional governments have not been able (or refused) to cut spending to any significant degree.

Quote from The Economist

Yet the real task of cutting social spending has barely begun. Spain’s 17 regional governments, which are responsible for education and health spending, jointly failed to reduce their deficits at all last year. They were the chief culprits, in fact, of Spain’s 2011 deficit miss, jointly accounting for an overspend worth 2.9% of GDP against a target of 1.3%.

Meanwhile in Italy, Mario Monti’s austerity plan is working better than ever and if Spain errs on the side of dissenting, Italy is head of the class. Monti was consequently able to deliver a budget deficit for 2011 at 3.9% of GDP which is a tad below the median forecast at 4% and significantly lower than that 2010 deficit of 4.6% of GDP.

The rough with the smooth here, however, is that growth in Italy has slumped.

We have shown this chart before and it has still not recovered. As such, it is obvious that the price paid for Italy’s fine performance on the austerity front is an absolutely shocking economic performance. This does not necessarily mean that Spain is right to kick back against its previous deficit target. What it does mean, however, is that when there is no economic momentum independent of government stimulus, austerity may not have the desired effect when the objective is to lower the debt-to-GDP ratio.

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