Why does the outcome of the Italian elections reshuffle the cards?

First because it comes as a surprise. A relative victory of the centre-left (Pier Luigi Bersani’s Democratic Party) would have meant a possible agreement with Mario Monti, resulting in a sufficient majority to govern the country and carry on with Mr Monti’s work. This was the scenario we all wanted to believe in.
This scenario did not materialise, however, given the return of Berlusconi, the emergence of Beppe Grillo’s movement and the disappointing results of Monti’s centrist coalition. There will be no possible continuity.  
The options taken by the three main protagonists do not seem compatible, at least from an economic viewpoint. There are pro- and anti-euro groups (Grillo, Berlusconi in part). Under these conditions, it seems difficult to reach political equilibrium. The local agreements that have often been mentioned only concern local issues. In a coalition government, issues are broader and seem poles apart. The only possible coalition would be one that deals just with non-economic issues. In today’s Italy, that is unrealistic.
Both houses are needed to govern, the lower house (Chamber of Deputies) and the upper house (Senate). Each house has the same weight in adopting laws (unlike in France, where the Assemblée Nationale, the lower house, plays a decisive part). This will not be the case. One option could be to set up a transition government to handle current affairs and organise new elections.
New elections will have to be held, even if a coalition government handles current affairs and deals with certain issues. I find it hard to imagine that two of the three parties susceptible of setting up a coalition will be able to agree on crucial, non-economic topics such as the electoral system – an issue often raised after the elections so as to enable a clear majority to emerge.
The scenario is therefore for a transition period as a lasting coalition does not appear tenable pending new elections.

What will be the impact on Europe?

The baseline scenario was for the newly-elected government to quickly request aid via the ECB and its OMT (short-term bond buyback programme). The anticipation of this momentum partly explains the drop in Italian interest rates in recent weeks or even months.
Failing a legitimate government, it will be impossible to set up this kind of programme, as it implies a long-term commitment. In return for using OMT, governments must undertake to set up clear measures concerning the budget, structural reforms and institutions. If new elections are scheduled, a transition government does not have this kind of authority. This means that any ECB bailout for Italy cannot be triggered at least until the results of the new elections.
This creates a new situation of uncertainty which is negative for the economy. The Italian economy contracted by 0.9% in the fourth quarter of 2012 (-3.7% on an annualised basis) and by 2.2% for the full year 2012. If Italian government bond rates remain above 4.5%, a strong and lasting recovery cannot be contemplated. Nobody will want to invest in these conditions. This will penalise the Italian economy and result in a further deterioration of the labour market, which could fuel the weight of “anti-euros” in Italian society, in particular for the next polls.
For other euro zone countries, lastingly sluggish activity in Italy will be a handicap. Italy is the third-largest euro zone country and an Italy in recession will severely hamper Europe’s momentum. For France, trade with Italy accounts for 8% of its exports.
Furthermore, the political uncertainty surrounding new elections will have a number of impacts. If in the interim Italy’s situation deteriorates further, this could attract more votes against Europe and the euro. More than half of votes more or less reflected this opinion in the polls of 24 and 25 February. This situation could worsen, indicating uncertainty about the euro zone’s effective momentum. If such an option were to materialise, investments in the euro zone would become more risky and it would not invite massive investments in the region.
That is why the Italian elections are bad news for the euro zone. They extend the period of uncertainty, which can only undermine the economic cycle.

The interpretation of the outcome of the elections reflects a fast-deteriorating economy. Is it that bad, for Italians to challenge the choices made in the past?

Three indicators provide information on the health of the Italian economy.

The first chart shows the rapid deterioration of the Italian economy in the last six quarters. There was a moderate rebound after the recession in 2008/2009, but this new reversal will drag activity down to new depths. This profile is very worrying as it will result in a sharp and rapid deterioration in employment.
The middle chart shows the drop in purchasing power. Purchasing power has been contracting since 2008 but the contraction in 2012 was even sharper due to the fiscal austerity measures implemented by the Monti government. This is a direct illustration of why Italians have rebelled against Europe, which has forced the country into austerity and therefore a significant drop in purchasing power.
The last chart shows the complexity of the Italian economy. The decline in exports during the severe contraction in global trade in 2008/2009 was sharper than for its European partners, while the rebound was far less pronounced than in Spain or Germany. The myth of an Italy with efficient SMEs out to conquer the world is dead. The Italian economy, barring a few leading luxury brands, is no longer capable of playing a key role in global trade. In other words, Italy can no longer expect spontaneous support from outside its borders. Even if global trade were to pick up, Italy would stand to benefit less than its European partners.
These three charts clearly explain why Italians were so depressed when they went to the polls. Spontaneously, activity is deteriorating and jobs are getting scarce, purchasing power is plummeting and exports are no longer competitive. Part of this pattern reflects the austerity policies implemented by Mr Monti but driven by Europe. The “anti” vote is not all that surprising given the extent of the shocks.

The ECB is often mentioned as being implicitly responsible for the outcome of the elections.

Economists and central bankers opposed to the concept of a central bank’s role as a lender of last resort in a financial crisis have suggested that the ECB’s proposals via its OMT programme were an asymmetrical commitment. The impact of the announcement led to a drop in interest rates, but without any formal commitments by governments (Italy and Spain, interest rates having fallen in both countries) to rebalance their public finances, as required by the OMT. The motivation for governments is therefore lower as the mere announcement of the transactions drove interest rates down. The fact that interest rates remained low gave the impression that the crisis was entering a resolution phase. Italians felt they could move on. This approach reflects that of the Bundesbank, which is opposed to the ECB’s intervening directly on public debt and believes these interventions can have dramatic consequences.
Just one remark: the charts presented above show deteriorations dating back to before September 2012. The Bundesbank is calling for more austerity and the Italians disagree.

Will the Italian situation trigger changes in the hierarchy of economic policies in the euro zone?

Euro zone countries that are in recession have been requested to implement highly restrictive policies to stabilise their public finances and to vote for structural reforms that can change the economic momentum, so as to renew with growth autonomously.
I believe that enforcing these two options simultaneously is a mistake. Structural reforms demand sea changes in the economy. Gaining more flexibility means applying new forms of work. Facilitating the allocation of resources in an economy implies creating new momentum in old European countries. Both households and companies need leeway to adjust and to come up with new strategies and new trajectories.

Enforcing austerity measures at the same time as a rapid reduction in public deficits leaves no room for these adjustments and strategic choices. You cannot do two things at once and there must be a choice between growth and balancing public finances. For the time being, given the resistance to change, austerity policies are being put forward, but this results in sluggish, nil or even negative growth, a deterioration in the job market and loss of revenue.

Austerity is shown on the blue curve of the chart below

Since the implementation of austerity measures, the curve has plunged. The private sector’s momentum has vanished. Must we wait for this to translate into heavy social unrest before we change and opt for growth?
Austerity policies will not necessarily revive growth. Does austerity generate productivity? More efficiency at work?
If the Italian crisis can result in inclining the hierarchy towards growth, with incentives for companies to accumulate capital, then the Italian crisis will have had a positive impact on the situation in Europe.

What are the risks of the situation?

A first interesting point is that the Italians have retaken responsibility for their political decisions and could well stop systematically putting the blame on Europe.
The most likely scenario is for new elections to be scheduled to fit in with the Presidential elections (indirect suffrage) in mid-May. In the meanwhile, unless the economic environment improves markedly, trends in activity and employment will influence behaviour. Barring an improvement by the next polls, the risk is for another massive vote rejecting Europe and the euro. This would be extremely worrying, lending more credence to the image of a fragile euro zone and triggering more volatility. It would harm the euro zone’s momentum and delay an upturn of the European economic cycle.
The other major risk is that the rest of the world will get tired of these shenanigans and lose interest in Europe and the euro zone. By striving to be virtuous at any cost, Europe could be left behind. This is already very much the case; we must try not to accelerate this trend.