All roads lead to Berlusconi’s Rome. For now.
The euro zoneâ€™s future hangs on Italy â€“ and Italyâ€™s future hangs on its politics. The best way forward would be a grand coalition replacing Silvio Berlusconiâ€™s discredited government. But after the prime ministerâ€™s Houdini act last week, that doesnâ€™t seem likely and other scenarios arenâ€™t as attractive.
Until recently, investors didnâ€™t pay too much attention to the multi-dimensional chess game that is Italian politics. The state may have nearly 2 trillion euros of debt, equal to 120 percent of GDP, Â but the country is rich: Net household wealth was 8.6 trillion euros in 2009, according to the Bank of Italy. The deal-making and back-stabbing in Rome â€“ or for that matter, Berlusconiâ€™s bunga-bunga sex parties â€“ didnâ€™t seem to matter. True, the country has virtually stopped growing in recent years. But there was even a view that Italy benefited from having politicians that were so concerned with their elaborate games that they couldnâ€™t interfere with the business of business.
All that changed in early July. As the euro crisis gathered pace, scandals and wrangling in Rome unsettled markets. The 10-year bond yield, which had been a relatively comfortable 4.8 percent, shot up to 6 percent in two weeks. Berlusconi and Giulio Tremonti, his previously respected finance minister, fell out. The center-right government, which survives on a wafer-thin majority, was able to pass austerity measures to cut the deficit. But the actions were seen as too little, too late. Investors became hyper-sensitive to Italian politics and were no longer willing to take things on trust.
The rot was only stopped by the European Central Bank wading into the market in August and buying Italian bonds. But even this bought only temporary respite. Despite two European summits last week designed to provide a comprehensive solution to the euro crisis, Italian yields ended the week back at 6 percent. The country is on the edge of a debt spiral as investorsâ€™ concerns about the country become self-fulfilling. If borrowing costs rise further, the countryâ€™s debts wonâ€™t seem sustainable, meaning yields could shoot still higher.
The best way of breaking the vicious spiral would be to have a positive political shock â€“ to counter the negative one delivered over the summer.Â And the best way of achieving that would be to have a temporary grand coalition led by a technocrat such as Mario Monti, the former European Commissioner. Its mission would be to take harsh actions needed to solve Italyâ€™s two big problems: debt and low growth. Labor markets would be liberalized; the bloated public sector would be cut down to size; and the over-generous pension system would be reformed. It might even be possible to reduce debt to below the psychologically important 100 percent mark by privatizing assets and instituting a one-off property tax.
Such an outcome doesnâ€™t look likely. Although Berlusconiâ€™s government has come close to collapsing several times in recent months, he has so far managed to pull it back from the brink. The latest crisis was caused by pressure last week from Germany and France to produce a stronger reform program. The Northern League, Berlusconiâ€™s main coalition partner, balked at this. In the end, a compromise was struck which was just enough to satisfy the European allies but not too strong to bring the government down.
This was a pity. If the government had collapsed President Giorgio Napolitano would have been free to call on Monti or somebody else to form a technocratic government. As it is, Berlusconi will now limp on with a lackluster reform program which will struggle to secure the support of the market.
Even worse, the government may not be able to implement its program. The decisive vote in parliament probably wonâ€™t occur until January by which time another three months will have been wasted. Whatâ€™s more, if the government falls at that point, the consensus in Rome — where I spent a few days last week — is that it will be hard for Napolitano to call on a technocrat to take charge and will instead be under pressure to agree to new elections. This is partly because Italy traditionally votes in the spring time and partly because the next elections have to be held anyway by mid-2013, meaning that a new technocratic government wouldnâ€™t have much time to achieve anything.
New elections in, say, March might not be so bad if they delivered a decisive outcome. But Italyâ€™s Byzantine politics make this far from certain. There are three blocs: the right, the left and the center. Current opinion polls show that the left would be the leading bloc but that it might not be able to form a majority without the support of the center. The center, though, is ideologically closer to the right â€“ although it would be loath to join them in a coalition if Berlusconi was still around. Further complicating the picture is that fact that each of the blocks is made up of several parties each with its own agenda.
What all this means is that new elections could easily produce a messy outcome. Even a clear victory by the left wouldnâ€™t necessarily be good. Pier Luigi Bersani, leader of Italyâ€™s Democratic Party, the main left-wing group, hasnâ€™t yet set out a clear agenda. Given that the party relies on support from unions, it might not be able to embrace the free-market reforms Italy needs.
There are, of course, other scenarios: BerlusconiÂ may get his diluted program through parliament; hisÂ government may collapse before the end of the year, allowing a grand coalition to take over; even if it collapses in January, Napolitano may find a way of bringing in a technocratic government. Meanwhile, the euro zone last week agreed ways to leverage the European Financial Stability Facility, its bailout fund. This means it should soon have a much bigger war-chest with which to support Italy if its bond yields climb higher. But the EFSFâ€™s resources are not limitless. If Italian politics remains dysfunctional, Europe could soon be back in crisis mode.