The upcoming Italian general election is increasingly looking like a two horse race as Silvio Berlusconi has staged a quite amazing comeback.
Quite apart from the fact that he was forced out of office amid a storm of criminal accusations barely 14 months ago, investors are worried that his anti-austerity, tax cutting stance could have profound implications, not just for Italy but for the euro area as a whole.
A little over a year ago, a grand bargain was struck by the main European leaders and Italy to install a government of unelected professionals in order to introduce the difficult reforms so necessary in the country.
Following the stench of scandal surrounding Silvio Berlusconi, the new prime minister, Mario Monti, was greeted as a breath of fresh air.
The yields on long dated Italian bonds duly started falling and it’s fair to say that, along with the European Central Bank’s long term refinancing operations, this was the start of the fight back against the financial forces that were threatening to tear the euro area apart.
Crucially, it gave the governments of other weak European economies extra confidence to press ahead with their own reforms in the face of fierce opposition.
For sure, Monti’s reforms at home were deeply unpopular, particularly the relaxing of labour laws and the imposition of a punitive property tax.
But with a debt-to-GDP ratio second only to Greece and the broad political consensus in favour of austerity, he was given the benefit of the doubt.
The thing with reforms is that the pain is felt now while the benefits are in a hazy and politically unsellable place called the future. Mario Monti inherited an economy heading into recession with an unemployment rate of 8.8% and a debt to GDP ratio of 120.1%.
He goes into the election at a time when the economy is deep in recession with an unemployment rate of 11.2% and, most troublingly, a debt to GDP ratio of 126.1%.
A populist politician loves statistics like these. He can claim that austerity hasn’t worked and that a new path is needed. He can say he will stand up against Angela Merkel and the rest who are imposing their draconian will on the economy and its people. Nevermind that excessive debts shackle the economy to years of stagnation.
People will point to the Japanese experience but Italy’s own history is just as pertinent, if not more. For over a decade, successive governments have tried in vain to stimulate the economy through fiscal policy and all this has achieved is higher debt – economic growth has remained stubbornly weak.
Furthermore, we forget that surging bond yields in 2011 were pushing Italy ever closer to a default and a bailout. Unfortunately, the austerity debate is difficult to couch in black and white terms, which makes it such an easy tool for political gain.
The Berlusconi renaissance
The latest polls show just how much of a swing factor austerity is proving to be.
According to the SkyTG24-Tecne poll, Mario Monti’s centrist grouping is languishing in a distant fourth place at 12.6% (behind a former comedian, incidentally) while Silvio Berlusconi’s right-leaning alliance has enjoyed a surge in popularity and is now garnering 29.4% of the potential vote, just 3.7% points behind left-leaning Pier Luigi Bersani.
Berlusconi has used his considerable political skills and media reach to set out an anti-austerity stance, including promises to cut taxes and to refund around €4 bllion from the proceeds of the property tax.
Mr Bersani and his party have a closer affinity with the labour unions than Monti does but he still plans to pursue reforms. And while Berlusconi has pledged not to be prime minister in a new government, enough votes will allow him to have a major say in any resulting coalition.
For the Italian people, the choice is between painful reforms and instant but short-lived reward.
For the Italian economy, the result seems increasingly likely to be political gridlock, fraught coalition negotiations and very little reform. The country’s fractious political system means we have been here many times in the past, but surely never before at such a critical juncture for the euro area.
The evidence from the other Southern European economies is pointing strongly to improvements in fiscal balances and increased competitiveness – for example, Spanish exports are growing nicely and the Greek government is rapidly approaching a primary surplus.
But this means little to people who see nothing but rising unemployment, falling salaries and higher taxes.
European economic growth is uniformly weak and set to stay that way for much of this year. In contrast, the US economy has almost completely avoided any form of austerity and its economy is recovering smartly. The long term outlook and a pressing US debt problem simply don’t matter enough to voters.
Just as the positive influence from Italy following Monti spread across the region and allowed austerity to continue, thus keeping bond yields in check, the election may trigger a reversal.
Rising bond yields, weak growth and unpopular austerity would be a toxic combination and the ECB’s newly established lender of last resort status could finally be put to the test.
Investors have been increasingly optimistic about the global economy but a crucial part of this has been the calmer waters in Europe.
There is still a chance that Italy’s politicians can emerge with enough impetus to keep the show on the road but, with an election race that is increasingly neck and neck, investors should brace themselves for turbulence.
Graham Wainer (pictured) is global head of investments - managed portfolios.