Oct. 1 (Bloomberg) -- A political storm brewing in Italy has the potential to disrupt the calm that has prevailed in the euro area. Europe’s leaders can only hope that markets will somehow prevent the currency union’s third-largest economy from backsliding too far on efforts to keep its debts under control.
Former Prime Minister Silvio Berlusconi initiated the latest drama on Sept. 27, when he withdrew his support for the country’s coalition government. Five ministers from his People of Liberty, or PDL, party then resigned, prompting Prime Minister Enrico Letta to suggest a vote of confidence will be held this week. As a result, there’s a significant chance that Italy will find itself without a government at a time when it should be passing a budget for next year.
Berlusconi’s stated rationale was that the coalition failed to scrap an increase in the value-added tax planned by the previous technocratic government. In reality, Berlusconi demanded his ministers resign to pre-empt his probable ouster from Parliament following his tax-fraud conviction. If we can count on one thing in Italy, it is for Berlusconi to always look out for Numero Uno.
Whatever Berlusconi’s motivation, his demarche is almost certain to lead to new elections -- the only real question is when. Letta has been scurrying to secure the support of enough PDL members to survive a confidence vote and keep his government going into next year. As of this evening, he appeared to be having some success: Senior PDL members were saying they didn’t want to topple the government.
So far, the market reaction to Berlusconi’s antics has been fairly muted, with Italian government bond yields inching up only slightly. If there were a snap election, however, it’s hard to imagine that the reaction would be positive. Investors would rightly wonder whether Italy will be able to pass a budget for 2014. This, in turn, would cast doubt on Italy’s one saving grace: its ability to maintain a small enough budget deficit to keep its extremely large debt burden from spiraling out of control, despite chronically low economic growth. The country is already set to overshoot the 2013 budget-deficit target it agreed to with the European Union.
The market’s concerns could be exacerbated by credit-rating companies, which are all poised to lower Italy’s rating owing to political instability. Investors whose mandates limit them to holding debt with certain ratings could be forced to sell Italian government bonds. Italian banks could face tougher limits on the amount of cash they can borrow against the collateral of government bonds, complicating their efforts to improve their balance sheets ahead of a new round of European Central Bank stress tests next year.
A snap election could also plunge Italy into a procedural mess. On Dec. 3, the Constitutional Court is due to rule on the legality of Italy’s electoral system, a decision that could require the government to amend electoral law. Depending on the timing of the vote, Italy might end up with no government in place to make the changes needed for an election to be legitimate.
German Chancellor Angela Merkel called Letta yesterday and highlighted the importance of political stability in Italy for Europe. If sufficient pressure is put on Italian politicians by other European countries and the markets, snap elections can be avoided.
Italian President Giorgio Napolitano, who is in charge of dissolving Parliament and calling new elections, is determined to explore all alternatives before allowing a snap vote. The best option would be for dissenting members of the PDL and the anti-austerity Five Star Movement to side with the current government (albeit with cabinet changes).
Failing that, Letta could still head a minority government if members of the PDL and Five Star Movement lend their support to passing the 2014 budget and the new electoral law. Berlusconi himself has suggested he might support such a government on the budget if it includes measures with which he agrees. Another option would be to install a temporary, technocratic government, just as was done in 2011 when Mario Monti was put at the helm of the country.
To be sure, avoiding a snap election now is just delaying the inevitable. Berlusconi has already demonstrated that he is willing to pull his support as soon as he doesn’t get his way. The government would still be hugely unstable and unable to implement the kinds of changes to Italy’s spending, labor and product markets that investors and the EU demand.
The EU should keep the pressure on Italy to hold its government together until after the 2014 budget and electoral law are passed. With a bit of breathing space, Europe’s leaders should then get to work on establishing the banking, political, economic and fiscal union needed for Italy to return to a sustainable debt trajectory over the longer term.
(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. She is also a senior fellow at the Atlantic Council in Washington.)
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