Italy’s Looming Political Crisis: Dancing Under the (Debt) Volcano

I have argued recently ( here) that the victory of the Berlusconi’s coalition in the March regional elections was a “Pyrrhus” victory. Mr Berlusconi’s People of Freedom party (PdL) lost votes to its main ally, the Northern League, and weakened considerably in the productive North. It did well in the South, however, where the League is virtually absent (1). As a result, Mr Berlusconi faces an unpleasant alternative. Either he concedes to the League’s requests for more “fiscal federalism” (meaning less Northern money transferred to the South) and undermines his party’s electoral support (particularly in the South), or he does not, and risk loosing the government’s majority in Parliament (and his own aspiration to become the next President of the Republic). The likely outcome is to put even more pressure on the budget (lower taxes to make North happy, and higher spending for the South), already strained by the recession.
Yesterday, the first political crack appeared in the PdL. In a dramatic showdown (live on TV), Mr Fini, the president of the Chamber of Deputies, and co-founder of the party, challenged Mr Berlusconi’s leadership. The party, a peculiar crossbreed between a fans’ club, a mystic sect, and a private business, had never before witnessed open criticism of the Supreme Leader. Mr Fini accused Mr Berlusconi of subservience to the League on issues such as fiscal federalism, law and order, immigration, and of lack of consideration for the South. Mr Fini’s opposition (both as minority leader and as President of the Lower Chamber) is likely to result in a war of attrition of parliamentary ambushes, resulting eventually in the party breakup and/or in political elections.
Heightened political uncertainty, we know from the empirical literature on sovereign default, is one the main drivers of sovereign debt crises and it will add to the pressures on debt described before. Another driver is low growth. Unfortunately, the IMF World Economic Outlook has cut the already lacklustre growth projections for Italy to 0.8% (from 1%) in 2010, and to 1.2 (from 1,3%) for 2011. In turn, low growth will exacerbate conflicts within the PdL and the government coalition.
These developments could not come at a worse time. Only yesterday, Moody’s downgraded Greek debt to A3 from A2 (on review for possible further downgrades), Eurostat’s revised estimates for Greek public deficit upwards to 13.9% of GDP, Greek interest spreads rose to almost 600 basis points and CDS spreads jumped from 485.7 to 638.9 basis points, sending shivers across European financial markets. The question is no longer whether a restructuring of Greek debt will take place (Papandreu asked today to activate the IMF-EU  45 billion euro rescue package), but whether this will be “orderly” or not, and, in the latter case, which of the PIIGS will be contaminated first.The looming political crisis in Italy is reinforcing the likelihood that Italy will be in pole position.

Footnote: 1 “It is sometimes now that we are observing this (sismic) activity on the Etna (the tallest European Volcano, located in Sicily) and the Vulcan is ready for a an eruption, even if it will not be anything to worry about (Enzo Boschi, President of the National Institute of Geophysics’ and Volcanology, 21 April 2010 ANSA )