Inconclusive election result creates a dangerous mess in Italy

"Italia ingovernabile", declared a headline in La Repubblica on Tuesday. No change there, then. There have been more than 60 elections in Italy since 1945. But the latest one has produced "a dangerous mess", as Economist.com puts it. Stocks slid worldwide and Italian ten-year bond yields jumped by more than 0.4 percentage points as a hung parliament threatened to reignite the euro crisis.

Political stalemate

The centre-left bloc led by Pier Luigi Bersani won the lower house of parliament but not the senate. A populist grouping led by a former comedian won 25% of the vote. Add to this the share of the vote clinched by the equally populist centre-right leader Silvio Berlusconi, and a "majority of Italians have voted against the Brussels consensus. That is a damning indictment," says Mats Persson of the Open Europe think tank.

Italy's previous government had begun to implement an austerity and structural reform programme to lower the deficit and boost potential growth. That had helped allay market fears that Italy wouldn't be able to get to grips with its huge debt pile. A promise by the European Central Bank (ECB) to buy peripheral debt in unlimited quantities, to stop bond yields and hence borrowing costs soaring to bankrupting levels, had a similar effect.

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But now the European establishment's recipe for restoring economic health has been rejected "in a country too big to fail and too big to bail out", says The New York Times. There seems practically no chance of a government emerging that is set to carry on the previous administration's reform agenda. In fact, there seems virtually no chance of a government emerging at all.

A grand coalition between centre-right and centre-left is implausible, "given how they stand for completely opposite policies", says Hugo Dixon on Breakingviews. A new election looks inevitable, but may not solve anything: there are three equal forces that don't want to work together.

Given all this, investors are set to get increasingly nervous, sending bond yields rising again to unsustainable levels. When the ECB promised to buy up debt last year, it didn't have to follow through because markets were placated by the mere idea of a backstop, as Jeremy Warner pointed out on Telegraph.co.uk. "It's possible that markets will now test the ECB's resolve afresh."

The snag is that, for the ECB to step in, countries have to agree to certain economic and fiscal measures. "There is not a snowball's chance in Hades of the Italian parliament now agreeing to the sort of conditions that would be imposed."

North versus south

"Contagion could return with a vengeance too," notes Dixon. Other highly indebted states may have more stable governments, but they also have shrinking economies and restive populations as recession and austerity continue to bite. "Investors may worry anew that the race between populism and the return of growth will be lost across the eurozone."

Political divisions between the stricken periphery and the northern states and the Brussels establishment, who have insisted on painful change, would deepen. Countries could be tempted to leave the eurozone in response to populations' demands for an end to economic pain.

A messy break up of the eurozone could easily cause another global crisis, however, and so, as we have often pointed out, the likelihood is that, if push comes to shove, the ECB will kick-start its bond-buying programme to avert a euro collapse.

More money printing won't solve the crisis, but it will calm the panic and give stockmarkets a boost. The next few months, however, says Dixon, are set to be "extremely jumpy".

How the trouble started

Italy's debt drama differs from those of other southern states. While much of the periphery was plunged into crisis by the global recession, Italy's problems have been building for two decades. Once the post-war boom abated, governments tended to juice growth through public spending and frequent devaluations of the currency, which boosted competitiveness.

Then Italy joined the euro. It lost the lira, and the club rules restricted governments' ability to rack up public debt.

That made it all the more important to keep a lid on labour costs to remain competitive, while liberalising the economy would also have helped create new sources of growth. But Italy has done neither.

An underlying politico-cultural problem, says Tony Barber in the Financial Times, is that the post-war system "distributes influence among political parties, industrial groups, banks, trade unions and other centres of power so carefully that no government can cut through the thicket of vested interests". Corruption "feeds more poison into the system".

The previous government led by Mario Monti has at least made a start, says The Economist. His pension, regulatory and labour-market changes have already raised Italy's growth potential by up to 0.5%. "But much more is needed." Italy is still being suffocated by too many layers of government and "protected" professions. Pharmacists and taxi drivers are among the professions that are hard for outsiders to break into and thus provide competition in.

All this has squeezed growth, which is crucial to reducing a debt pile now worth 130% of GDP, a European record. After this election, it's no wonder markets are again worried that Italy is not going to be able to cut debt. It's not impossible to change Italy, says The Economist. Just very difficult. And now it has become more difficult still.