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Why the Italian Vote Is a German Failure

Sunday, 3 Mar 2013 | 10:19 PM ET
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Signals sent by the Italian election have (a) reaffirmed changes in the euro area fiscal consolidation policies, (b) strengthened the area's integration process, (c) forced Italy to face stark choices and (d) created conditions for euro area's better policy mix.

Austerity-Only Policies Are Over

Even Germans apparently knew that huge and precipitous budget cuts demanded of the deeply indebted euro area countries would, at some point, hit a dead end. That point has been reached. Sinking economies and soaring unemployment are depressing tax revenues and making meaningful deficit reductions impossible and politically intolerable.

(Read More: Italy Election Punches Hole in European Central Bank's Euro Defenses)

Social unrest is growing. People see no end to unbearable hardships, and a bleak future awaits an entire generation of jobless and seemingly hopeless youth. Strikes and riots in Greece, Spain and Portugal have found a new political expression in one-fourth of the vote obtained by a three-year-old Italian party that wants to tear down the political system.

Italy's former Prime Minister Silvio Berlusconi staged his stunning political comeback, and came within less than a percentage point of winning the last week's election, on an anti-austerity, anti-German platform, mixed with promises of rescinding a widely resented and highly regressive real estate tax.

Some very conservative German media are taking the Italian vote as a failure of Chancellor Angela Merkel's "cold" and "hostile austerity diktat." I, therefore, thought that the Netherland's finance minister – a country serving as the key enforcer of German austerity-at-all-cost (as long as the costs are not theirs) policies – showed an incredible chutzpah when he lectured the U.S. Congress last Friday that it would be a real tragedy (sic) if mandated spending cuts were to stifle American economic growth. There, apparently, is no such tragedy when these things are happening in the euro area.

Italian elections have put a stop to that nonsense by reaffirming the demise of austerity-only policies and unrealistic fiscal consolidation schedules. Despite German and Dutch resistance, the EU Commission will now accept less stringent but closely supervised euro area fiscal policies. Depending on their particular cyclical conditions, euro area countries can take longer to reach their deficit targets. France, for example, experiencing stagnant economy and rising unemployment, has been allowed until 2014 (instead of 2013) to deliver the mandated budget deficit of 3 percent of gross domestic product.

Strengthened Euro Area Integration Process

Enhanced supervision of the euro area countries' budget process by the EU Commission is part of the sovereignty transfer required by the fiscal compact – the founding document of the future fiscal union - agreed in late 2011. That agreement also upheld earlier limits to euro area budget deficits (3 percent of GDP) and public debt (60 percent of GDP).

The banking union – currently being implemented by the European Central Bank (ECB) and the EU Commission – is the other pillar of the euro area's integration process.

The Italian crisis is adding new urgency to the completion of fiscal and banking unions. These two institutions – and the significant shared sovereignty they imply - are seen as stepping stones toward an original political union of confederated nation states. That, of course, is the ultimate goal of the euro area, but irrevocable intermediate steps in that direction will lead to jointly determined fiscal policies and conditional financial transfers.

That is the essence of the German call for "more Europe." The principles of further steps toward euro area's economic and political integration will be spelled out in a joint French-German document the countries' leaders are scheduled to announce next June.

Italy Will Muddle Through

By March 25, Italy's political leaders must agree to some form of coalition government. A minority government is also possible with ad hoc voting alliances. A government of experts is not to be excluded either, especially if experts are clean, competent and working on an agenda that gives some hope of better government and improving economy in a country where the unemployment rate just hit an appalling 11.7 percent in January.

(Read More: Italy's Has Choice of 'Two Clowns': Wilbur Ross)

Meanwhile, investors should beware of experts pretending to know, and/or understand, the Italian political process. Nobody does. Italians are quintessential and very creative artists of improvisation ("combinazione" in the vernacular).

But one thing is certain: either Italy gets some form of government and continues credible economic reforms and fiscal consolidation, or the markets - with active help from Germany et al. - will force Rome in an IMF-EU-ECB ward where these policies will be imposed. Since the Italian public opinion does not want a euro exit, the political class will probably decide that the former is better, and that it is less humiliating to be in a conditional lending program run by one of their own - the ECB President Mario Draghi.

A Better Euro Area Policy Mix

Since the Italian crisis is likely to grind on - with another round of elections a near certainty over the next year - the euro will remain under pressure because the ECB will continue to maintain easy credit conditions while signs of the Fed's less accommodative stance will become increasingly more evident.

(Read More: Italy President Snubs German Candidate Over Clown Gaffe)

A weakening exchange rate is what the euro area – not just Germany – wants. That would temporarily boost the area's competitive position on world markets because it would amplify the advantages of declining unit labor costs. The recent decision by Ford, Renault, Volkswagen and Nissan to expand their production in Spain is a case in point. These manufacturers are taking advantage of Spain's falling labor costs and newly introduced measures of flexible labor markets.

The Italian crisis – the country's powerful political leader, the comedian Beppe Grillo, would probably call it "commedia dell'arte" – offers plenty of interesting trading opportunities as long as you don't fall for the incongruous idea that this is the end of the euro area.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.

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