The surprise downgrade of Italy's sovereign debt overnight by Standard and Poor's exposes the fatal flaws of pushing through draconian austerity measures on a nation experiencing economic weakness.
Cutting services and raising taxes will slow economic growth, making heavily indebted countries like Italy and the rest of the eurozone periphery more of a credit risk than ever before. This creates a downward spiral in which a country becomes dependent on bailouts until it finally defaults. The volatility created by this downgrade will produce a considerable amount of uncertainty in the markets in the coming weeks, keeping many investors on the sidelines.
S&P downgraded Italy's long-term and short-term sovereign debt rating one-notch to A/A-1. The nation was put on a "Negative Outlook" by S&P in the summer as the euro crisis intensified.
At 1.9 trillion euros, the Italian debt market is one of the largest and, up until this summer, one of the most liquid debt markets in the world. In downgrading Italy, S&P said it was concerned that the country could be shooting itself in the foot by passing a massive austerity plan last week. It fears that the plan could lead to "more subdued external demand," therefore reducing economic growth. This reduced growth rate would then make it unlikely that Italy could hit its fiscal targets, like attaining a balanced budget by 2013.
Italy didn't take on this 55 billion euro austerity plan on a whim -- it was essentially forced to do it by the European Central Bank. Earlier this summer, the euro contagion caused investors to step away from Italian bond auctions, forcing Italian bond yields to skyrocket. This increased Italy's funding costs and raised the possibility that there could be a failed auction for future debt offerings. Italy depends on rolling over its huge debt load to stay solvent, so a failed auction would be devastating.
To offset this risk, the ECB came out and started buying Italian bonds on the secondary market, essentially taking the place of skittish private investors. This move by the ECB was done on the condition that Italy meets certain fiscal targets to get its economic house in order. It was similar to the demands placed on Greece last year when that nation's debt market froze up, forcing the ECB and the International Monetary Fund to bail it out.
Growth is key