The euro crisis is all about Italy now

11/07/2011 2:44 pm EST


Jim Jubak

Founder and Editor,

Need more evidence that the financial markets have turned their attention from Greece to Italy?

Prime Minister George Papandreou announces an agreement with the opposition New Democracy Party—normally the material for a rally--and the euro still falls against the dollar and the yen in trading in Asia overnight and Asian stocks fall on worry over the key parliamentary vote in Italy on Tuesday. Hong Kong’s Hang Seng Index closed down 0.83% and the German DAX close down 0.63%.

Prime Minister Silvio Berlusconi could fail to muster a majority for a vote on the country’s 2010 budget report. Two Berlusconi allies defected last week and a third quit on Saturday. Six others have called for his resignation in an open letter to newspaper Corriere Della Sera. Italian 10-year government bonds, which traded to yield 6.4% on Friday, look set to sink further in price and rise further in yield despite heavy buying by the European Central Bank.

Meanwhile back in Athens, in what would be market moving news absent developments in the Italian crisis, Greek Prime Minister Papandreou has agreed to step down to allow the formation of a national unity government. That government will have two jobs: Get the necessary measures passed in Parliament to implement the euro debt deal of October 26 and then to step aside to allow new national elections.

If the new government can pull off the first of those two tasks it will take Greece and the EuroZone back to where they were after the October 26 announcement of a deal intended to stabilize Greek finances and expand the power of the European Financial Stability Facility to intervene in fragile bond markets. That agreement still had a lot of big holes that needed to be filled—what incentives would be offered to banks in exchange for marking down the value of their holdings of Greek government debt by 50%, for example. All that was put on hold when Prime Minister Papandreou called for a national referendum on the deal. Now the process of approving the deal—in Greece—and filling in the details—in Brussels—will get started up all over again.

On the one hand that means that all that has been lost is two weeks—assuming that the new unity government can get the votes it needs. But on the other hand in reality the delay has done deep damage to confidence in the ability of EuroZone governments to cope with this crisis. Instead of triumphantly presenting an agreement to last week’s meeting of the G20 nations, leaders of the EuroZone such as German Chancellor Angela Merkel and French President Nicolas Sarkozy were forced to take the Greek and Italian prime ministers to the wood shed. None of the developing economies that had seemed likely to invest in the European Financial Stability Facility would do so given the level of uncertainty. And, most importantly, instead of creating a firewall that might have stopped the crisis from spreading to Italy, the chaos so undermined confidence in the EuroZone that Italy has now moved to the center of the crisis.

I don’t see any European institution—and that includes the European Central Bank—that is prepared to move forcefully and quickly enough to create even a pause in the Italian debt crisis. I think only a Berlusconi resignation has the power to give Italy and the EuroZone the breathing space to act. (A Berlusconi resignation in favor of something like a government of national unity on the Greek model would likely produce a significant relief rally in financial markets.)

Stay tuned to see how tomorrow's vote in Italy goes. The short-term uncertainty is, of course, unnerving to markets, but the market could actually get a temporary resolution not too far down the road in Italy.

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