Since late July 2011 when Mario Draghi, the president of the European Central Bank, vowed to do whatever it took to save the Euro, all has been relatively quiet on the Euro front. Sadly, yesterday’s highly disappointing Italian election results are almost certain to end that quiet. Italy will now be entering a prolonged period of political instability. Its electorate has also given the clearest of thumbs down to the idea of continued fiscal austerity and structural economic reform policies being required of it by its European partners.
The Italian election results were very much worse than even the pessimists had feared. No political party emerged from the election capable of securing a working majority in both houses of parliament. Making matters worse, the populist Five Star Party, which is against both austerity and continued Euro membership, garnered as much as 25% of the vote. Meanwhile, the party of Mario Monti, the outgoing prime minister favored by Angela Merkel, managed to secure barely 10% of the vote.
Last year, the Italian economy contracted by around 2.5% while in the fourth quarter of 2012 it declined at an annualized rate of 3.5%. The last thing that a faltering Italian economy with high unemployment needed was a blow to investor and consumer confidence from political instability and higher interest rates. Yet that is precisely what Italy got yesterday. This has to heighten the chances that the Italian economy will decline in 2013 by a lot more than the 1% being forecast by the European Commission. Were that to occur, it would almost certainly fuel the anti-austerity political backlash, worsen Italy’s public finances, and further weaken the Italian banks.
The lack of an effective Italian government and a domestic anti-austerity backlash will make it very difficult for the ECB to backstop Italy in the event that it were to be shunned again by foreign bondholders. In order for the ECB to buy Italy’s bonds, the ECB would require that Italy negotiate an economic adjustment program with the European Stability Mechanism and with the IMF. Absent Italy being in a major financial crisis, it is difficult to see how Italy can muster the political will to agree to more fiscal austerity and structural reform that the ECB would require of it.
Anyone who still thinks the Euro crisis is over has simply not being paying attention to economic and political developments in Italy, the Eurozone’s third largest economy. They also have not being paying attention to the fact that Italy’s mounting woes are occurring at a time of deepening economic recessions and rising political difficulties in Greece, Portugal, and Spain.