By Desmond Lachman
If ever one needed evidence that excessive money printing by the Federal Reserve and by the Bank of Japan was seriously distorting global market prices, all one need do is to look at the EUR 2 trillion Italian sovereign-debt market. For despite the clearest of evidence of a marked deterioration in the Italian political and economic outlook, over the past three months Italian government bond prices have rallied to their strongest levels in the past two years.
The current mispricing of Italian government bonds is most unfortunate. Since not only does it remove pressure on Italian politicians to get their country’s political and economic house in order. It also lulls European policymakers into a false sense of security that somehow Europe is going to muddle through its sovereign debt crisis without basic institutional changes to the European Monetary Union.
The troubling outcome of the February 25 Italian parliamentary elections, together with the considerable difficulty in electing a new Italian president, provides a measure of how dysfunctional Italian politics has become. Not only did the electorate hand a resounding defeat to the technocratic government of Mario Monti, which had been installed a year earlier at the behest of German Chancellor Angela Merkel and the European Central Bank to restore order to the Italian economy. Rather the election also marked the rise of the populist Five Star Party. This latter party is led by Beppo Grillo a stand-up comedian, who is best known for his vehement anti-establishment invective and for his disdain for politics as usual.
Tapping into deep public discontent about an ever worsening economic recession and about pervasive corruption throughout the Italian political system, the Five Star Party garnered close to 30 percent of the vote. This put it ahead of both the established center-left and center-right parties. Equally troubling was the fact that over 60 percent of the Italian electorate voted against the budget austerity and structural reform program being demanded by Brussels to place Italy’s public finances on a sustainable path.
No clear path forward
In the two months since the election, Italy has not been able to form a government. No party commands sufficient votes to form a government on its own, while deep mistrust and resentment between each of the three main parties precludes cooperation to form a stable government. This makes it all too likely that new Italian elections will be called for within the next six months.
It is far from clear that a new election will provide a more favorable result than did the last election. Indeed, with the center-left party now in disarray, it is all too likely that Silvio Berlusconi’s Forza Italia Party will once again regain the government despite its truly dismal past record in office. It is also all too likely that in the run-up to the election each of the political parties will pander to the electorate by promising tax cuts and increased public spending. This will make it difficult for a new Italian government to pursue a responsible budget policy.
Buoyed by very cheap money in the United States and Japan, international markets are choosing to ignore Italy’s deteriorating economic and political fundamentals. Instead markets seem to be taking comfort in the European Central Bank’s commitment to do “whatever it takes” to save the euro in general and to provide a backstop to the Italian and Spanish government debt markets in particular by buying unlimited quantities of those countries’ bonds.
An unsustainable path
A critical factor that markets seem to be overlooking is the fact that the ECB’s offer of support to the Italian government bond market was conditioned upon Italy negotiating an economic adjustment program with the European Stability Mechanism and with the International Monetary Fund. Markets also seem to be overlooking the fact that such an adjustment program requires Italy to have in place a government that is committed to economic adjustment. This is far from certain in Italy’s present economic context particularly when one considers the all too real likelihood that Italy’s heightened political instability is driving the Italian economy more deeply into recession.
The market is hardly doing Italy a service by failing to signal the unsustainable path on which Italy’s public finances now seem to be. For it enables the Italian political system to continue on a business as usual basis and to delay the needed economic and economic reforms to address the country’s excessive public debt problem. This runs the very real risk of making the Italian economy all the more vulnerable to a change in global liquidity conditions when that occurs.
Similarly the market is not doing Europe as a whole a service by removing pressure for institutional reform that might put the euro on a sounder footing. On the contrary, by breeding a false sense of complacency among European policymakers about the ability of the governments in the European periphery to finance themselves in the market, the markets are undercutting the case of those advocating a move to a banking union and a fiscal union that would seem to be the necessary conditions for the Euro’s longer run survival.
Should in the end the euro unravel, markets should bear their share of the blame for failing to have played a disciplinary role on both Italian and European policymakers by their current mispricing of Italian government bonds.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.