Monday, February 25, 2013

Italian Voters Sack Markets in the Rest of the World




The markets today were blindsided by events in the Italy. The Italians had an election yesterday that has returned a split between the lower and the upper houses such that a government cannot be formed. Not all the results are in but it looks as though Silvio Berlusconi is going to win a blocking plurality of the Senate and the centrist Bersani is going to win the lower house. This is something of an upset. Originally Bersani was favored to win but a last minute surge for a Beppe Grillo, a comedian turned anti-corruption and anti-austerity activist, pulled votes away from him and left Berlusconi with a majority in the Senate. Due to the nature of the Italian Constitution there is some ambiguity as to who will be invited to form a government and if there is not enough clarity new elections in May might be needed. What is clear is that the Italian electorate is not a big fan of government austerity nor by implication the broader strategy of the EU in handling the Eurozone crisis.

So what was the reaction to all this? Well, it was something close to panic. Markets which had been up decently in the morning fell and then more or less crashed. The S&P touched a high of 1525 this morning then pretty much fell all day to close on its lows of 1488, down about 1.8%. European markets got totally destroyed. Why is this? Well, if you recall, the main story in world markets for most of the last three years has been a series of near death experiences of the Eurozone. First Greece went through a near death experience and then, for the private sector bondholders at least, an actual death experience. Then for most of 2011 and the first half of 2012 Italy and Spain were in something of a race to see who would be pushed into bankruptcy first and these bankruptcies were in a race with the EU officials and the European Central Bank to see who, if anyone could put the pieces back together again.

In Italy there was a lot of concern that the country would fold and since its economy is very large that it could take the whole EU down with it. So great were these fears that in November 2011 Silvio Berlusconi was forced from office and replaced by Mario Monti who then enacted a number of unpopular but necessary reforms and began to calm the Italian markets but the panic then moved to Spain.  Then about six months or so ago Mario Draghi the president of the ECB basically said that he would do everything in his power to ensure that the Eurozone did not break up including, conditional on a troubled country taking a rescue from the ESM and imposing its conditions, buying outright the bonds of that country similar to what the Fed is doing in the US with its quantitative easing. Since then the markets have breathed much much easier, Spanish and Italian bond yields have fallen and people have begun to think that the worst was behind us.

Yesterdays election, by showing that the people of Italy are somewhat less inclined to support the continuation of the Monti reforms, much less the draconian policies that would be required under the terms of an ESM rescue package that would trigger ECB bond buying just let the air out of the Draghi hope balloon and resurrected the spectre of a voluntary default or Euro-exit by a major European economy. Either a default or a Euro-exit (which, since the debt is denominated in Euros, would be swiftly followed by a default) would almost certainly destroy the European banking system and with it the European Economy and with that the stability of the world economy. Ergo: mass-hysteria in the worlds equity, currency, and bond markets. Now keep in mind we are in fact a long long way from any of these negative outcomes actually happening and it may well be that cooler Italian heads will prevail (in the event that cool headed Italian is not a contradiction in terms.)

Something that is worth pondering though, if you are an avid reader of Paul Krugman or pretty much any of the people decrying the coming sequester battle you might just ask yourself, "gosh, if the Italians are voting down austerity, shouldn't that be a GOOD thing? I mean, Krugman says that what is destroying Europe is austerity, surely a step away from this would be good. And also didn't President Obama just go on TV today and say that these budget cuts would be bad for the economy?" The trouble with the views of Krugman, and less so Obama is that once you have enough debt you can't just vote your way out of austerity. Stimulus can only be paid for in so many ways: taxation, borrowing and money printing. Italy can't print it's own money. It doesn't want to pay taxes or cut spending. OK fine but what do the bondholders have to say? Well, until Monti arrived on the scene and Draghi announced his intentions to buy the bonds of countries that imposed austerity they were saying, "that's all well and good but we would prefer to not buy your bonds. Actually, not only that, we're prefer to sell the ones we already have. What's more, once we're done selling all our Italian bonds, we'll take it a step further and sell the hell out of Italian banks that we know are loaded to the gills with Italian bonds and can't sell them. 

So even if the voters try to vote "No!" to austerity their vote is not the final one cast. The final one is cast by the bondholders and their vote is probably going to be "Ciao!"

By the way my fellow American Generation Xers and Millenials, this kind of thing is coming within our lifetimes to a Republic near you.

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