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.