Crashing Germany's austerity drive

Italy showed that it is ready to don Berlin's fiscal hair-shirt overnight with the Italian Senate giving its blessing to Prime Minister Mario Monti's deficit-cutting measures.

Rome's latest austerity package is seen as critical in convincing Berlin that Italy is serious about shoring up its finances. And Monti was keen to show there was widespread political support for his latest €20 billion ($A26 billion) austerity package, calling for a confidence vote even though his month-old technocratic government boasts a parliamentary majority.

But the austerity measures – which include a property tax on first homes, higher retirement ages, and measures to crack down on tax evasion – are less popular with Italian citizens, who are already struggling with a slowing economy and rising living costs. Last week, Italy's national transport system was crippled by a strike, and more unrest is expected in coming months after Monti unveils his major labour market reforms.

Even though Monti is scrupulously following Berlin's rule-book on budgetary austerity, financial markets are far from convinced that it is the right solution to Italy's debt problems. They worry that stringent budget cutbacks in countries like Italy will only push the economy further into recession, which will severely dent tax revenues and cause the country's budget deficit to widen, and its debt burden to swell.

Overnight, Italian 10-year bond yields edged up to 6.85 per cent, despite the fact that the previous day the European Central Bank had flooded the European banking system with €489.19 billion ($640 billion) in low-interest loans.

Some, including French President Nicolas Sarkozy, had been hoping that banks would use the cheap ECB loans to buy the bonds of countries such as Italy. For instance banks, which pay a 1 per cent interest rate on their 3-year ECB loans, would be able to buy 2-year Italian bonds that currently yield close to 5 per cent. As a result, banks would earn a 4 per cent interest rate spread on their investment. If banks bought large quantities of Italian bonds, Italy's interest rates would fall, easing pressure on the country's budget.

The problem is that banks are far from convinced that Berlin's austerity plan will work. Berlin is counting on the fact that by the time these ECB loans come to be repaid – some time before 2015 – countries such as Italy and Spain will have slashed their budget deficits, reformed their labour laws and boosted their competitiveness.

But what happens if Berlin's plan fails? Banks are increasingly worried that Berlin's austerity drive will spark a backlash in debt-laden eurozone countries, with growing demonstrations and strikes as citizens revolt against further austerity and recession.

And even if countries such as Spain and Italy can introduce tough budgetary measures and major labour market reforms, they're unlikely to boost their productivity levels enough to gain ground against countries such as Germany. As a result, they'll struggle to boost their exports sufficiently to compensate for the slump in domestic demand.

As a result, banks are increasingly concerned that a number of the weaker debt-laden eurozone countries will decide that the easier option is for them to exit the eurozone, default on their debts, and massively devalue their currencies in order to regain competitiveness. Even if only one eurozone country took this route, it would create turmoil in financial markets.

As a result, Europe's banks are likely to use the ECB loans to cover their own maturing debts (they have to pay back €725 billion ($953 billion) in debt next year, including €280 billion in the first three months), rather than gambling on Berlin's solution.