Anatole Kaletsky

Financial markets, which balance judgments from some of the world’s most highly paid and best-informed analysts, are often uncannily right in anticipating unpredictable events, ranging from economic booms and busts to elections and terrorist attacks. But markets can sometimes can be spectacularly wrong, especially when it comes to politics. A classic case was the slump on Wall Street after last November’s election in the United States. This week’s market action in Europe may offer an even clearer example of market confusion about two fascinating but Byzantine political entities – the Italian government and the European Central Bank.

European stock markets have rebounded strongly this week in the face of deteriorating economic and financial fundamentals from across Europe on the basis of two political events: the reluctant agreement by Italy’s 87-yearold president. Giorgio Napolitano, to serve another seven-year term because nobody else could be found to do the job; and hints from ECB council members that they might vote to cut interest rates from 0.75 percent to 0.5 percent next Thursday.

Neither of these events remotely justified investors’ euphoria. The ECB case is straightforward. First, the ECB may well disappoint next week, since several influential decision makers oppose a rate cut. Second, even if the ECB does act, a quarter-point cut will do nothing for growth. Third and most importantly, such a tiny rate cut, if it happens, will simply underline the ECB’s refusal to follow the U.S. Federal Reserve, the Bank of Japan, the Bank of England and the Swiss National Bank in expanding the money supply or taking other “unconventional” measures that could potentially have a much greater financial impact than any marginal fiddling with interest rates. So much, then, for the silly idea in Europe that “bad news is good news” because economic weakness will force the ECB to cut rates.

Italian politics is, as ever, more interesting and convoluted. The apparent winners from this week’s events were the strongly pro-euro President Napolitano and his new center-left prime minister, Enrico Letta. In fact, they were the losers. The real winner was Silvio Berlusconi, the nemesis of Napolitano and other responsible Italian politicians and a totemic hate figure for German Chancellor Angela Merkel, along with most other respectable European leaders.

To understand this counterintuitive conclusion, which is widely shared by the financiers and business leaders I met in Italy this week as the election drama unfolded, let us begin with what most investors and responsible politicians across Europe interpreted as this week’s good news. Napolitano’s re-election, denounced by comedian Beppe Grillo’s populist Five Star movement as an “elite coup d’etat,” has allowed the aging president to appoint a politician from the center-left Democratic Party (PD), which secured the largest share of votes in last February’s election, to head a pro-euro technocratic administration likely to be modeled on the outgoing government of Mario Monti. Thus, Italy will now have a functioning democratic government, and one that will stick to most of the Monti policies approved by Brussels and Berlin. Moreover, this government is likely to be stable for at least the next six months, since all the established parties have agreed that a new electoral law must be prepared before the next election to prevent a repeat of the present chaos and to try to block Grillo’s advance.

Whisper it softly, but the age of government austerity is ending. It may seem an odd week to say this, what with the U.S. government preparing for indiscriminate budget cuts, a new fiscal crisis apparently brewing in Europe after the Italian election and David Cameron promising to “go further and faster in reducing the deficit” after the downgrade of Britain’s credit. But politics is sometimes a looking-glass world, in which things are the opposite of what they seem.

Discussing the outcome of Friday’s “sequestration” of U.S. government spending is best left to the month ahead, when we see how the public reacts to government cutbacks. But in Italy, Britain and the rest of Europe, this week’s events should help convince politicians and voters that efforts to reduce government borrowing, whether through public spending cuts or through tax hikes, are both politically suicidal and economically counterproductive.

In Italy, and therefore the entire euro zone, this shift is now almost certain. After the clear majority voted for politicians explicitly campaigning against austerity and what they presented as German economic bullying, further budget cuts or labor reforms in Italy are now off the agenda, if only because they would be literally impossible to implement. If Angela Merkel demands further budget cuts, tax hikes or labor reforms as a condition for supporting Italy’s membership of the euro, a majority of voters have given an unequivocal clear answer: Basta, enough is enough. Most Italians would rather leave the euro than accept any further austerity – and if Italy left the euro, total breakup of the single currency would follow with an inevitability that might not apply if the country exiting were Greece, Portugal or even Spain.

We don’t yet know the winner of Sunday’s election in Italy, but the losers are already clear. And in this election, who loses may be much more important than who wins.

The obvious loser is Mario Monti, the charming and eloquent economics professor who is widely credited with saving Italy from a Greek-style debt crisis during his one-year term as Italy’s unelected prime minister. Monti could have gone down in history as the most effective and intelligent Italian leader of his generation, had he decided to opt out of this weekend’s election and instead sought appointment as Italy’s president. That is a mainly ceremonial role that can become very important in times of constitutional crisis (which in Italy occur all too often), and Monti could almost certainly have won strong endorsements  from Italian politicians on the left and right.

Instead, Monti surprised everyone by founding a political party and running for Parliament at the head of a center-right grouping. This now looks like a big mistake. According to the last pre-election polls, Monti’s group is running a humiliating fourth, after the Italian Socialist Party, Silvio Berlusconi’s resurrected personal party and stand-up comedian Beppe Grillo’s anarchic Five Star Movement. Worse still for Monti, he seems to have helped his archenemy Berlusconi by splitting the opposition to the scandal-ridden former prime minister. If Monti’s party performs as badly as expected, it will be all too easy for his opponents to present the election as a clear rejection of the painful economic reforms he imposed on his long-suffering countrymen at the behest of the German government and the European Central Bank.

Remember the euro crisis? For most of 2012, politicians, investors and business leaders were almost unanimous in their belief that the possible breakup of the euro would be a massive risk to the world economy. But today the euro is 5 percent higher against the dollar than it was six months ago, European stock markets have outperformed Wall Street by 11 percent in the same period, and Italian government bonds have been among the best investments of 2012.

The Nobel Peace Prize conferred this week to the European Union included three men who, under the EU’s byzantine institutional structure, are all entitled to be called “President of Europe.” With the award, it seemed as if the euro crisis might be almost over.

Silvio Berlusconi burst back onto the EU stage this month with his trademark chutzpah and slapstick timing, disparaging the technocratic government that has been given credit for putting Italy back on the road to financial prudence and thereby saving the euro.

The words “core” and “periphery” have become standard terms to describe the winners and losers in the euro crisis. But how could anyone with the slightest sense of history, or knowledge of art and culture, call Italy or Spain peripheral to Europe, while placing Finland and Slovakia, or even Germany and Holland, at Europe’s core?

As a part-time resident of Italy, with a home 100 km from Rome, the center of two millennia of European civilization, I could not be satisfied with this trite answer. Speaking to friends and neighbors in Italy this summer and observing the behavior of Europe’s leaders, I have been struck by a more interesting, and disturbing, explanation of the core-periphery split. These terms do not refer to the past or the present, but to plans for the future. Core and periphery are not geographic or historical descriptions, but euphemisms designed to legitimize permanent economic and political inequalities among the nations of Europe.

With every step toward a resolution of the crisis, the peripheral countries have lost political autonomy, economic opportunity and national self-esteem, while the core countries, especially Germany, have been enriched and empowered. By creating conditions in which the interest rates paid in Italy, Spain and the other Mediterranean countries are much higher than they are in Germany and its northern allies, Europe has imposed a large and permanent economic handicap not only on the governments of southern Europe but also on their private businesses and households.