Hugo Dixon

The austerity debate misses half the point. It is true that governments, especially in the euro zone, shouldn’t chase an austerity spiral ever downwards. But they can’t just sit on their hands. They must drive even harder for structural reforms.

The last few weeks have witnessed a sea-change in the debate over fiscal austerity. A seminal academic paper by Carmen Reinhart and Kenneth Rogoff, which purported to show that economic growth was impaired if government debt levels exceeded 90 percent of GDP, has been discredited.

Meanwhile, the European Commission has softened its line on the merits of further deep budget cuts in peripheral economies. Spain, for example, looks like it will get until 2016 to bring its deficit down below the European Union’s magic number of 3 percent of GDP. Portugal, Greece, Italy and France are also being shown greater leniency by Brussels. One of the first things Enrico Letta, Italy’s new prime minister, said last week was that country needed to focus on growth not austerity.

The change in attitude didn’t all happen in the past few weeks. The International Monetary Fund, which in the old days used to be considered the high priest of austerity, has been advocating looser policies for a good year. And, as more countries have got sucked into the austerity spiral – slamming on the brakes, which crushes the economy, making it harder to hit budget targets – the folly of continuing with the same policies has been hard to ignore.

It is astonishing to think that it was only in December 2011 that virtually the entire EU, including most countries outside the euro zone, signed up to the German-inspired “fiscal compact” – a misguided treaty which hardwires austerity into governments’ constitutions. It will be interesting to see whether this has any residual role or, like the euro zone’s original growth and stability pact, is viewed as a piece of waste paper.

Italy could do with some market pressure. Rome’s bond yields are now lower than they were before February’s inconclusive election. But as the politicians scheme, the economy burns. With markets calm, there is insufficient urgency to crack on with long-needed economic and political reform.

The fall in 10-year bond yields, which were 4.3 percent on Friday compared to 4.4 percent just before the election, is attributable to two factors. First, nobody wants to bet against the European Central Bank which has promised to do whatever it takes to preserve the euro. Second, the Japanese central bank’s pledge to buy gigantic quantities of bonds at home has buoyed asset prices elsewhere, including in Italy.

The backdrop to the current political crisis is starkly different to that in November 2011, when a sharp increase in bond yields created a panic which led to Silvio Berlusconi being forced out of office. Now none of the three main political blocs – Berlusconi’s centre-right group, the centre-left Democrats and Beppe Grillo’s 5-Star Movement – can govern on its own. But seven weeks have been wasted without a coalition being formed.

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.

One knee-jerk reaction to Italy’s shock election was to worry about contagion to Spain. As Rome’s bond yields shot up last Tuesday, Madrid’s were dragged up in sympathy. These are the two troubled big beasts of the euro zone periphery and an explosion in either of them could destroy the single currency.

But Spain, where I spent part of last week, probably won’t catch Italian flu. True, the risk of Madrid being thrown off its reform path has risen since Italy’s inconclusive election. But Prime Minister Mariano Rajoy doesn’t have to face the voters for nearly three years. What’s more, the Italian vote may make euro zone policymakers less keen on austerity and so give Spain a better chance of returning to growth.

Indeed, investors have already started having second thoughts. By Friday, Madrid’s 10-year bond yield had fallen back to 5.1 percent from 5.4 percent on Tuesday. The spread between Spanish and Italian yields has shrunk to 0.3 percentage points. There’s even a chance that Madrid could enjoy lower borrowing costs than Rome in the coming weeks if Italy’s political paralysis shows no sign of resolution.

Can the Italians be serious? That is likely to be the reaction of financial markets and the country’s euro zone partners as they ponder a disastrous election result, which could reignite the euro crisis. More than half of those who voted chose one of two comedians: Beppe Grillo, who really is a stand-up comic; and Silvio Berlusconi, who drove Italy to the edge of the abyss when he was last prime minister in 2011. Both are anti-euro populists.

This comedy could easily end in tragedy. The inconclusive result has echoes of last year’s first Greek election – except that Italy is bigger and more strategic. The country faces political paralysis, while its economy is shrinking and its debt is rising. The European Commission forecast last week that GDP would fall a further 1 percent this year after last’s year 2.2 percent drop. Debt, meanwhile, would reach 128 percent of GDP by the end of this year.

The euro crisis went into remission after the European Central Bank’s president Mario Draghi promised last summer to do “whatever it takes” to preserve the single currency. But, if Italy proves ungovernable during this critical time, even the ECB’s safety net may not work.

Should an investment bank worry about a client’s motive when it engages in a complex and potentially suspicious transaction?

Monte dei Paschi di Siena (MPS) has been just such a client. The Italian bank, which has just been rescued by the state, engaged in a series of fiendishly complex deals with Deutsche Bank, JPMorgan and Nomura which had the effect of giving a misleading picture of its finances.

One controversy relates to how MPS paid for its acquisition of Antonveneta, another Italian bank, in 2008. JPMorgan helped finance part of the deal by selling 1 billion euros in so-called FRESH notes, a type of bond convertible into MPS equity. But the Bank of Italy objected that they were not sufficiently loss-absorbing and insisted that MPS only pay money to JPMorgan to forward onto the investors if it made a profit.

The Monte dei Paschi di Siena saga is not just an Italian affair. Revelations that complex financial transactions used by the country’s third largest bank had the effect of hiding losses are causing a political storm in Italy.

With a general election only weeks away, Silvio Berlusconi looks like being the main winner from the political spat. The former prime minister’s camp has attacked Pierluigi Bersani’s Democratic Party, which is leading in the opinion polls, for being close to Monte dei Paschi (MPS). It has also criticised Mario Monti, the current prime minister, who agreed to increase MPS’s bailout to 3.9 billion euros.

The scandal won’t be enough to get Berlusconi back as prime minister. But it could prevent a Bersani-Monti coalition from running the country with a solid majority in both houses of parliament. If so, fears about Italian political risk could return to haunt the markets.

The last Italian prime minister whose surname began with a “B” – Silvio Berlusconi – was a disaster. The country’s next leader’s name is also likely to start with a “B”.

Investors want Mario Monti, the technocrat who took over from Berlusconi last year, to stay as prime minister after the election, which will probably be in March. But they are more likely to get Pier Luigi Bersani, leader of the left-wing Democratic Party (PD). While there are risks, such an outcome may not be as bad as it looks – not least because Bersani has promised to continue with Monti’s policies and was one of the few reformers when Romano Prodi was prime minister in the last decade.

Trade union-backed Bersani will be the standard-bearer for the left in the coming elections after winning a decisive primary at the weekend against Matteo Renzi, the modernising mayor of Florence. His first comments were promising: he said the PD would have to tell Italians the “truth, not fairy-tales” about the country’s grave economic situation.

Is Francois Hollande more like Mariano Rajoy or Mario Monti? In other words, is the French socialist president condemned to be always behind the curve with reform like Spain’s conservative prime minister? Or can he get ahead of it like Italy’s technocratic premier?

I put this question to my fellow guests at a dinner in Paris last week. France is not in imminent risk of blowing up, as wrongly implied by the Economist magazine, which used a cover picture of a lighted fuse on baguettes tied together like sticks of dynamite. France is much richer than Spain and its people are more willing to pay their taxes than the Italians. French 10-year borrowing cost is only 2.1 percent, compared to Italy’s 4.9 percent and Spain’s 5.9 percent.

That said, the country has three deep-seated problems which could ultimately cause a mega-crisis: public spending at 56 percent of GDP is way too high; industrial competitiveness has steadily eroded; and the population is in a state of denial. The last cannot be said of either Italians or Spaniards.

The European Central Bank’s bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone’s two large problem children and, with them, the single currency.

Mario Draghi’s promise in late July to do “whatever it takes” to preserve the euro has already had a dramatic impact on Madrid’s and Rome’s borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.

Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank’s financial firepower is theoretically unlimited, whereas the euro zone governments’ own bailout funds do not have enough money to rescue both Spain and Italy.