Exit Berlusconi, Enter Uncertainty

It was a busy weekend in Italian politics. The Chamber of Deputies passed the latest round of austerity measures, Prime Minister Silvio Berlusconi resigned, and President Giorgio Napolitano mandated Mario Monti, a respected economist and former EU commissioner, to form of a new government of national unity. The backdrop to all this frenzied activity was the country’s growing liquidity crisis: As Italy, the world’s third largest bond market, saw its borrowing costs rise to unsustainable levels in recent weeks, the rest of the planet could only watch in numb horror, as if observing a slow-motion car crash.

On Monday, as Monti was in talks with the political parties for the formation of the new cabinet—made up almost exclusively of unelected technocrats—the main index of the Milan stock exchange opened with a 1 percent jump. By the end of the session, though, it was down 2 percent as were the main indices in Spain (-2.2 percent), Germany (-1.2 percent), and France (-1.3 percent). The Italian government was able to sell 3 billion euros worth of five-year bonds, but the interest rate rose to 6.29 percent, almost 100 basis points higher than last month.

Are the markets irrational? Wasn’t Berlusconi the problem, with his endless antics and his inability to push through necessary reform? And therefore, shouldn’t his exit from the scene and his replacement with a serious-minded economist of impeccable credentials lead to a return of calm and the renewal of investor interest in Italian bonds? After all, as European politicians and officials constantly remind us, Italy is not Greece: It is a solvent country with a strong industrial base and a history of primary surpluses. And if the markets, being jittery beasts, insist on questioning Italian prospects, European solidarity will put them in their place by guaranteeing that Italy will fully repay its debts. The trouble with this account is that it overestimates both Berlusconi’s culpability for Italy’s current credit woes and the effectiveness of the Eurozone’s “solidarity.” It also leaves out the damage done to Italy’s position by the obsessive call for immediate austerity that emanates primarily from Berlin, Paris, and Frankfurt (the seat of the European Central Bank).

Start with Il Cavaliere, as Berlusconi is called: He has been the dominant force in Italian politics since he first bounded to power in 1994. As that, he bears heavy responsibility for his failure to re-energize the Italian economy by cutting red tape and opening closed professions—in the previous decade, Italy was one of the slowest-growing countries in the world. But he did not create the networks and the vested interests that keep the country lagging behind.

It’s true that, had Berlusconi been successful in implementing the necessary reforms, Italy’s debt levels would be lower today (they stand at 120 percent of gross domestic product, the second highest in the eurozone after Greece), and the country would not be in such a vulnerable position. But at the same time, Italy had been coasting along with very low growth rates and high debt ration for years, with nary a peep of protest from the bond markets. Indeed, countries with much healthier debt-to-GDP ratios, like Spain (projected to reach 69.6 percent in 2011), are themselves facing liquidity problems today, even though their fiscal management has been perfectly adequate.

This brings us to the other blind spots in the idea that Berlusconi was to blame for Italy’s economy and that his disappearance will allow the country to escape the horrors of contagion. As I argued at the time, the “firewall” set up by the eurozone at its summit on October 26—whose “comprehensive solution” to the euro crisis proved even more pathetically short-lived than its predecessors—to protect countries other than Greece from partially defaulting on their obligations was not worth the paper it was written on. The markets saw through the vague, weak attempt to leverage the European Financial Stability Facility to increase its size. Within days, egged on also by news of the ill-starred Greek referendum, they had sent Italian ten-year yields well above the psychological and financial barrier of 7 percent.

As Italy has gradually entered the eye of the euro storm in the last three months, the response from the eurozone authorities has been monotonous to the point of distraction (and destruction). Rome must get serious about fiscal austerity and structural reform, they say. Only thus will it regain the confidence of investors. The country has passed two major austerity bills in the space of two months. At the recent G-20 in Cannes, it was even agreed that the International Monteary Fund would come to Italy to “monitor” its policy progress.

The problem with all this is that fiscal retrenchment, in a country with sluggish growth, in a wider economic environment that is worsening fast, is bound to lead to a slowdown or worse. According to Eurostat’s September forecast, Italy was projected to grow by 0.5 percent this year and 0.1 percent in 2012. These numbers may turn out to be too optimistic. Even if the new Monti government is able to overcome the resistance of entrenched interests and make real progress in opening up the Italian economy, the benefits in terms of increased growth will take years to appear. In the meantime, because Italy is indeed not Greece, the Germans, the French, and the ECB should allow it greater freedom to boost economic activity and thus prevent the further deterioration of its debt position. They should also, finally, do what is necessary to guarantee liquidity in the Italian bond market. Berlusconi was just a front. The country’s real problem right now is Germany's Angela Merkel and France's Nicolas Sarkozy.