Markets too sanguine about Italy

By Hugo Dixon
March 11, 2013

The markets are too sanguine about Italy. The country’s politics and economics are messed up – and there are no easy solutions. And while Rome does have the European Central Bank as a backstop, it may have to get to the brink before using it.

Investors had jitters after last month’s election result, pushing 10-year bond yields up to 4.9 percent from 4.6 percent. But by last Friday they had fallen back to 4.7 percent. Investors have convinced themselves that some political solution will be cobbled together; that, if one isn’t, it doesn’t really matter; and that, if the worst comes to the worst, the ECB will pick up the pieces by buying the country’s bonds.

Mario Draghi, the ECB president, gave some support for the latter two ideas last week. He downplayed the risks to Italy’s fiscal position by arguing that much of the country’s belt-tightening was on “automatic pilot”. He also made clear that the ECB’s bond buying plan was still available for countries that followed the rules.

But messy politics and economics could make each other still messier. Months of political paralysis will squash investment and could dampen consumption. That will exacerbate the recession. Fitch Ratings – which downgraded Rome’s debt to BBB-plus from A-minus on Friday – thinks GDP will shrink 1.8 percent this year. A deeper recession, meanwhile, means a worse fiscal position. The ratings agency expects government debt to reach nearly 130 percent of GDP this year.

Political stalemate also means Italy won’t get to grips with its long-term problems. The country has barely grown in the last 20 years. Even Mario Monti’s technocratic government did little to address problems such as inefficient bureaucracy, red tape, cartels, a dysfunctional legal system and inflexible labour markets.

Without a long-term growth plan, Italy’s debt level may not be sustainable despite a budget surplus before interest payments of roughly 3 percent of GDP. But further belt tightening would be hard to implement given the electorate’s reluctance to back austerity. So Draghi’s automatic pilot may not secure a safe landing.

What solution then is there to paralysis? Participants at the Ambrosetti Forum, which I attended in Cernobbio last week, had three main scenarios: a grand coalition, a minority government and new elections. None looks like a recipe for stable government.

The essential problem is that the Italian electorate is split three ways – with each of Pier Luigi Bersani’s centre-left Democrats, Silvio Berlusconi’s centre-right PDL and Beppe Grillo’s upstart 5-Star Movement gaining nearly 30 percent of the vote. Meanwhile, Grillo refuses to work with either of the other groups and Bersani won’t form a coalition with Berlusconi.

The electoral system makes things worse. It has given the largest grouping, the Democrats, a majority in the lower house but nobody is in control of the upper house. A majority is needed in both houses to govern.

Optimists say it may be possible to form a grand coalition if Bersani and Berlusconi make way for new leaders. Matteo Renzi, Florence’s young mayor who lost out to Bersani in the Democratic primary, would be an obvious choice. In an opinion poll last week by SWG, he was the favourite to be prime minister with 28 percent support compared to 14 percent for Bersani, 13 percent for Grillo and 10 percent for Berlusconi.

The snag is that Renzi doesn’t have support either in parliament or among the Democratic party machine. What’s more, a grand coalition could easily collapse in bickering. Time would have been wasted and Grillo would be well placed to become the biggest group in a subsequent election.

Some observers think this wouldn’t be too bad. After all, the former comic wants to give the political system a much needed shake-up. The snag is that “Grillonomics” is pretty scary. The former comedian is advocating a 20-hour week and restructuring Italy’s debt. He is also playing with the idea that Italy should quit the euro.

If a stable government can’t be formed, aren’t new elections the solution? The problem is they would probably produce another stalemate. The best hope for breaking that would be if Renzi was the Democrats’ candidate. But even that might not work. Although he appeals to the centre ground, some of the Democrats’ left-wing supporters might peel off to more extreme parties.

Another hope is that a minority government, led by Bersani, could somehow hang on until the tectonic plates shifted enough inside parliament for a grand coalition to be formed. But Bersani will struggle to get such a minority government up and running. Even if he does, it is likely to collapse having achieved nothing except waste time.

Optimists hope the voting system could be changed before a second election. But even that seems unlikely. Although Bersani, Berlusconi and Grillo all want a new system, they have different ideas on what it should look like.

The most likely scenario then is that Italy will be forced into a second election which will still produce no clear winner. If the 5-Star Movement is the largest party, markets could panic. If one of the other two comes out ahead, there will have to be renewed discussions over a grand coalition. Even then, a further rise in bond yields may be needed to knock heads together. Meanwhile, the recession will drag on and the fiscal position will worsen. Not a pretty picture.

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