Hugo Dixon

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 still-murky saga has also put Mario Draghi under the spotlight because the ECB president ran the Bank of Italy when MPS was getting into such a mess. Giulio Tremonti, who was finance minister in Berlusconi’s last government, tweeted that it was “stupefying” that Draghi had failed to discover or prevent the complex transactions.

The Italian central bank’s defence is that, while some of its supervisors knew about the transactions, it did not know that they were linked to other loss-making operations because key documents were hidden from it. What’s more, even though it was worried about MPS’s weak risk management, it didn’t have the power to fire bank directors, despite Draghi requesting the last Berlusconi government for such authority. Its moral suasion did, though, eventually help remove the old MPS management last year.

Mario Monti’s ability to take a crisis and turn it into an opportunity may one day be taught as a case study in political economy. When Italy’s technocratic premier succeeded Silvio Berlusconi last November, the country’s 10-year bond yield was above the 7 percent level that had driven Greece, Ireland and Portugal to seek bailouts. Now it is 5.5 percent – still high but moving in the right direction.

Countries with high debt levels like Italy – its borrowing is 120 percent of GDP – are prone to self-fulfilling prophecies on both the upside and the downside. If investors think a government will go bust, borrowing costs rise which, in turn, makes bankruptcy more likely. But if markets think it is solvent, borrowing costs fall and that means it’s unlikely to fail.

In Italy, where I spent much of last week, there have been spirals within spirals. One has been via domestic politics. Monti has so much credibility that he has been able to reform the pension system, liberalise a raft of monopolistic industries and launch a high-profile crackdown on tax evasion. That has helped cut Italian bond yields, further boosting his credibility.

The Super Mario Brothers need to work together to save Italy and the euro.

Even if Mario Monti can form a strong government in Italy, the euro zone is vulnerable to bank runs and a deflationary spiral. Stopping that is the role of Mario Draghi, the European Central Bank’s boss. The zone needs vigorous supply-side reform but looser monetary policy. With Silvo Berlusconi gone, the duo and Germany’s Angela Merkel should try to forge a new grand bargain based on this.

Last week witnessed both the Italians and the Greeks dragged to the brink, look into the abyss and dislike what they saw. The two countries have or are in the process of forming national unity governments led by technocrats. This is a step in the right direction. But dangers abound.

The biggest risk is of a visible bank run. There has already been massive deposit flight in Greece as savers fear that the country could get kicked out of the euro – a scenario which is still real despite Lucas Papademos’ appointment as prime minister. But so far there have been no queues outside branches as there were with the UK’s Northern Rock in 2007. If that were to happen, television pictures would be relayed across Europe in seconds potentially provoking copycat runs.