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Why Italy’s Election Has Caused Global Markets to Crater

Provided by Business Insider's Joe Weisenthal

Last night's election in Italy is resulting in remarkable market gyrations all around the world.

  • US stocks had their worst day since November.

  • The VIX (a measure of volatility and fear) had an enormous surge.

  • The Italian stock market is down nearly 5% today.

  • The euro is cratering.

  • The Japanese stock market lost over 2% night.

So why does an election in Italy have this kind of huge impact?

"Italy is a massive economy; Greece is nothing compared to Italy," says professor William Black of the University of Missouri at Kansas City of Europe's third largest economy in the accompanying video with The Daily Ticker's Henry Blodget. "Austerity in the middle of a recession is a terrible policy."

To understand that, you need to understand the essence of the Euro crisis, and how it's been addressed by Eurozone leaders over the last year.

In a nutshell the Eurozone crisis started in late 2009, when investors in the bonds of peripheral countries (Greece, Spain, Italy, etc.) started to wonder whether those governments were "good for it" so to speak. The brutal recession combined with the massive banking bailouts required in some countries to seriously stretch their national balance sheets. And since no individual Eurozone country has their own printing press, there's actually the chance that they could run out of cash and default.

The initial attempt to address the crisis was via austerity and limited bailouts. But they didn't work. Austerity only aggravated the economies, further expanding the deficits. And the bailouts weren't enough to address the core problem.

The crisis only began to get "solved" in late 2011 when the one entity with unlimited money, the European Central Bank, began flexing its muscle. First it backstopped European banks. Then in mid-2012, ECB chief Mario Draghi offered a deal. The ECB would purchase the debt of any country, provided said country agreed to various structural reforms (reforming labor, reducing spending, reducing pensions, etc.).

Just as in the US, there's a big thirst among elites for structural reforms to reduce long-term deficits.

This promise made by Draghi -- which was called the OMT program -- was incredibly powerful. Just the knowledge that the ECB stood ready to buy the debt of struggling countries has dramatically reduced the borrowing costs of all the peripheral nations. Italy has seen a HUGE reduction in its borrowing costs.

Here's a 1-year chart of the yield on the Italian 10-year bond.

That peak last July occurred right when Mario Draghi first hinted at his new program. Ever since then, national borrowing costs have been dropping nicely, even though the ECB hasn't actually purchased a dime of Italian debt using the program.

So the essence of the new European stability comes down to this promise.

The ECB says it will buy government's debt, provided that said government engages in various reforms that the ECB wants to see.

There's only one catch. Voters hate austerity. And voters hate when their own politicians are taking their cues from an institution like the European Central Bank, rather than domestic needs.

And that's the phenomenon that came home to roost last night.

The political parties seen as continuing along the existing ECB-preferred path did badly. The rebellion voters (Silvio Berlusconi and populist Beppe Grillo) did much better than expected.

And this has the potential to undermine all of the progress made in Europe over the past several months. As Morgan Stanley explained in a research note this morning:

In order to activate the OMT, political authorities will have to apply and accept additional conditionality. This is what Italy’s electorate appears to have rejected.

(By "conditionality" they mean, the quid-pro-quo whereby the ECB bailout comes with austerity conditions.)

Italy is Europe's single largest debt market. Its debt to GDP is a staggering 120%. Banks around Europe are loaded to the gills with Italian debt. Suddenly, the debt backstop that everyone thought was there (the OMT program) may not be usable, because the voters just gave a huge rejection of pro-austerity politicians.

So now banks around the world are tanking because of their exposure to Italian debt, or because of their exposure to other financial institutions that are exposed to Italian debt. Or maybe they're exposed to Irish, Spanish, French, and Portuguese debt, where politicians might be looking at what just happened in Italy, and thinking: If pro-austerity politicians can get shellacked like that, then maybe we need to rethink and renegotiate our current programs.

And when you have financials taking a beating like this, pretty much everything goes down everywhere.

Evn in Japan, things took a beating since there was a huge flight-to-safety bid for the Japanese Yen, and since so much of the Nikkei rally lately has been associated with a weakening yen, a strengthening yen caused stocks to crumble.

As for what happens now? We'll learn more in the next few days.

The word everyone is tossing about is "ungovernable" which is a dramatic way of saying that no coalition can be formed (because no allied parties got enough seats), thus requiring new elections in a matter of weeks or months. At a minimum, this period of uncertainty will cause any further reform/austerity progress to come to a screeching halt.

It is possible that a government could be formed (perhaps even an alliance between the leftist Pier Luigi Bersani and Silvio Berlusconi) and that things will settle down.

But the key idea is that voters just went dead against the core deal in Europe, which is an ECB backstop in exchange for austerity. Strike at that, and you create the conditions for a new wave of the European crisis that extends beyond Italian borders.

SEE ALSO: Why European voters just staged its first rebellion >