Italy’s troubled coalition, a product of last February’s inconclusive elections, is on the brink of another collapse following the decision of former Prime Minister Silvio Berlusconi to pull his party out of the ruling coalition government.
Italy’s chronic instability could lead to further downgrading of the country’s credit rating, raising its borrowing costs, adding to the budget deficit, and in a worst-case-scenario, reigniting the eurozone crisis across the continent.
After Standard and Poor’s demotion of Italian debt to two notches above junk in July, Italy was warned that further downgrades could be possible if they did not demonstrate “institutional and governance effectiveness.” Prime Minister Enrico Letta, well aware of the potential consequences, has warned his coalition government that Italy can ill-afford higher costs in servicing its public debt, with its budget deficit for 2013 currently forecasted to overshoot the 3 percent limit agreed upon with the Europrean Union (EU). Just last week, Letta was assuring Wall Street investors that Italy was “young, virtuous, and credible,” only to return to Rome where a coalition collapse appears imminent.
On September 29, Berlusconi issued a defiant call for snap elections after forcing five of his ministers to resign from the five-month-old coalition in response to Letta’s Democrats moving forward with an increase in sales tax on October 1. Beppe Grillo, leader of the anti-establishment Five Star Movement, has also called for snap elections stating that Italy’s electoral law is unfair and should award a majority bonus to the party that wins the most votes, which in the last election would be his party. Letta and President Giorgio Napolitano have stated they will exercise all available options to avoid dissolution of the government, and will seek a parliamentary vote of confidence this week.
If Berlusconi succeeds in overthrowing the government, he has said he would be prepared to support a 2014 budget if it showed convincing proof of “being useful” to the country. It appears, however, that Berlusconi will never get that chance. The former prime minister is unlikely to be able to run for office (let alone lead), following his conviction for tax fraud. His one-year sentence, to be served through house arrest or community service, is expected to start in late October. Further, on October 19 a Milan appeals court is due to set the term for Mr. Berlusconi’s ban from public office. Legal issues aside, there have been numerous signs of disunity in Berlusconi’s Forza Italia party which indicates that Letta will be able to garner the necessary support to keep his coalition moving forward.
Year-end elections for Italy would be unprecedented and risk derailing the government’s 2014 budget, which is to be presented to Brussels and then parliament in mid-October. The decision to take down the government is completely at odds with warnings by the IMF and the European Commission that Italy needed to stabilize their political environment in order to stay on track with an expected exit from its recession by the end of 2013.
If Italy does end up going to the polls, the budget could end up being written by the troika of the European Commission, the European Central Bank, and the IMF. Such an outcome was avoided in 2011 when Berlusconi’s center-right government was unraveling under combined pressure of internal rifts, panicking financial markets, and his European counterparts. Instead of dissolving the government, Napolitano persuaded Berlusconi to resign and replaced him with technocrat economist Mario Monti. As that experience was ultimately politically destabilizing and unpopular with Italians, it is unlikely to be repeated.
Whether Mr. Berlusconi intends to follow through on his push for snap elections, or to use his leverage to dictate the government’s fiscal policy over the next two months of budget debate, it is clear that the threat of a political and economic crisis will never be far away. The IMF recently predicted that Italy’s economic prospects are grim, projecting that the economy will contract by 1.8 percent this year, that the budget deficit will increase to 3.2 percent of GDP, and the public sector’s overall debts will climb to 133 percent of GDP. After a tumultuous weekend, Italian bonds fell for a third day on Monday September 30, sending the yield of 10-year benchmark bond 18 basis points higher to 4.52 percent.
Italy’s political woes often reverberate far outside its borders. Given that it is the third most indebted country while also the third-largest bond market in Europe, Italy is large enough to bring down the eurozone as a whole. It is both too big to fail, and too big to bail. Just as European markets have begun to gain relative confidence and stability, the Italian political drama has proven to be an unnecessary and unwelcomed curveball.
Jordan Smith is an intern with the Global Business and Economic Program