Everything you need to know about the Italian political crisis - which is 9 years in the making and could bring about the demise of the eurozone

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The Course of Empire Destruction by Thomas Cole

  • Italy's political crisis has deepened over the weekend, with a fresh election in the country now a near certainty.
  • Many commentators now believe that the turmoil in the eurozone's third largest economy has started to pose a threat to the wider euro area.
  • Markets are spooked with major European assets selling off aggressively.
  • Business Insider looks at how Italy got to this point of deepening crisis.

Whisper it quietly, but the eurozone may be about to plunge headlong into another crisis, as the political situation in its third largest economy, Italy, deteriorates rapidly.

Almost three months after an inconclusive election left the country without a government, Italians could be headed back to the polls imminently with no end in sight to the rising crisis.
Italy's political situation is notoriously complicated, so Business Insider has tried to break down exactly what's going on, and why it's all happening now.

A nation in crisis

The growing crisis can trace its roots all the way back to 2009, with the foundation of the Five Star Movement, which in less than a decade has grown to be the single largest party in Italian politics, winning 222 out of 630 seats in the Chamber of Deputies at March's election. The chamber is Italy's lower house of government.

The party's policies don't fit neatly into the traditional left-right political spectrum, something it is keen to emphasise. It is variously anti-establishment, Eurosceptic, anti-immigration and pro-green. The "Five Stars" refers to its five flagship issues: publicly owned water, sustainable (eco-friendly) transport, sustainable development, right to internet access, and environmentalism.

Five Star's popularity has led it to moderate its stance on certain issues, and install a new leader, the 31-year-old Luigi Di Maio, who replaced Five Star's founder, comedian Beppe Grillo, in October 2017.

Luigi Di Maio of the 5-Star Movement looks on as he attends a news conference in Rome, Italy March 23, 2017. REUTERS/Alessandro Bianchi

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Luigi Di Maio of the 5-Star Movement looks on as he attends a news conference in Rome

Such political shape shifting has allowed Five Star to grow its popularity rapidly, and put it in its current position as Italy's largest and most powerful party.

However, while it emerged from March's election as the biggest party, Five Star fell well short of being able to form a government on its own.

This posed problems. For several years the party said it would not be willing to enter into a coalition government or power sharing agreement with any other party. That's because much of Five Star's appeal has been based on its rejection of the country's establishment parties, which it believed to be corrupt.

After becoming the biggest party in March, however, Luigi Di Maio relented, sensing the opportunity to govern the country. Over six weeks of talks with various parties followed, until eventually late last week it looked as though a government would be formed by Five Star in coalition with the Lega Nord, a right wing party led by Matteo Salvini.

The League, as they are often known, previously had ties to Silvio Berlusconi's Forza Italia party, but moved toward Five Star when an opportunity to govern presented itself.

The League and Five Star's alliance is an uneasy one, but the parties managed to put together a program of government that removed some of the more extreme policies from both sides - like plans to leave the euro - and just about pleased President Sergio Mattarella (who must approve any programme of government) enough to govern.

Late last week it seemed as though the League/Five Star alliance would be governing Italy, with law professor and political novice, Giuseppe Conte as prime minister. Mattarella had reluctantly agreed to allow Conte to form a government, and it looked like months of deadlock were finally coming to a close.
That was until Mattarella began the process of approving the coalition's appointments to key offices within government. Under Italian law, the president can reject the appointment of an elected official.

Trouble with the finance minister

FILE PHOTO: Italian President Sergio Mattarella leaves at the end of his consultations at the Quirinale Palace in Rome, Italy, December 10, 2016. REUTERS/Alessandro Bianchi/File Photo

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Italian President Sergio Mattarella.

All was going well until Mattarella got to the two parties' nomination for finance minister. The coalition had put forward Paolo Savona, a highly Eurosceptic economist and former banker who was Minister of Trade and Industry in the 1990s.

Savona has frequently advocated Italy's leaving the euro, describing the single currency in a recent book as a "German cage." He has been highly critical of Germany in particular, saying in the book that: "Germany didn't change its idea on its role in Europe after the end of Nazism, even if it abandoned the idea of imposing itself militarily."

He also claims that Italy's decision to join the euro back in the 1990s, has "halved Italians' purchasing power."Such assertions were enough for President Mattarella, a europhile, to reject Savona's appointment as head of Italy's economic and fiscal policies.

Mattarella told reporters that it's important for confidence in broader financial markets that Italy signals its intentions to remain part of the euro.

"Membership of the euro is a fundamental choice for the future of our country and our young people," he said.

Mattarella's rejection of Savona as finance minister means that he had rejected the entire mandate of Five Star and the League to govern. This, understandably, caused outrage from the two parties, with Luigi Di Maio calling for Mattarella's impeachment. Matteo Salvini, the League's head, stopped short of such calls, but did criticise Mattarella's decision.

The rejection of the coalition left Mattarella with two choices: call another election, or attempt to appoint his own technocratic government.

Mattarella sprung for the second option, and on Monday appointed former International Monetary Fund official Carlo Cottarelli as interim prime minister with a task to try and form a new government and bring order to political and constitutional turmoil.

Cottarelli is likely to struggle to form a government, as he will need to have the support of at least half of the country's 630 deputies to rule with any sort of efficacy. Given that the League and Five Star account for 347 of those deputies, and will obviously not approve a Cottarelli government, it seems impossible that Italy will have a government any time soon.
With no foreseeable path to a working government, it looks like the only option for Italy will be to hold another election, with the most likely outcome of that election being a strengthening of support for Five Star and the League. Indeed a poll released on Monday evening showed the League increasing its vote share by almost 5% from the election.

Dutch bank ING summed up the situation, with economist Paolo Pizzoli writing to clients (emphasis ours):

Should he [Cottarelli] manage to obtain the parliament confidence, he would try to have the 2019 budget approved, and resign before the end of 2018, taking the country to new elections in 1Q19. Instead, should he fail to get the parliamentary confidence, he would resign and remain in office as a caretaker for ordinary business, taking the country to new elections after August. We believe the chances of the government passing the confidence vote are extremely slim, and hold an autumn vote (in September or October) as our new base case.

It is still too early to understand where the party leaders will position themselves in view of the upcoming election. Chances are that the perceived institutional wound might induce both the Northern League and the 5SM to radicalize their electoral message, but different political possibilities remain possible.

"His chances of succeeding are slim and elections are likely in September. Which leaves us 3-4 months of uncertainty ahead of a vote that may be seen as a referendum on Euro-membership," Kit Juckes, a strategist at Societe Generale wrote on Tuesday morning.

Markets are spooked

Any such vote could be disastrous given that Italy is one of the three most crucial members of the eurozone project, alongside France and Germany.

Such an outcome seems to be something that senior figures in the eurozone are taking seriously. According to Yanis Varoufakis, who was Greek finance minister during the height of the country's last debt crisis, plans are being made for Italy's exit from the euro, which is being variously known as "Italexit" and "Quitaly."

"I have it on good authority that the German finance ministry, the European Central Bank and every major bank and corporation have plans in place for the possible exit from the eurozone of Italy, even of Germany," Varoufakis wrote in an editorial for the Guardian newspaper.

Perhaps the simplest way to imagine the eurozone is as a three-legged stool. Germany, France and Italy are the legs holding up the rest of the project. Remove any one of those three pillars and the stool falls over.

Simply put, if Italy goes, it's basically curtains for the euro area.

This prospect has markets freaking out on Tuesday, with assets selling off sharply across a broad spectrum. Here's the full wrap from Business Insider's Australian markets team:

  • Yields on Italy's 2-year debt rose by almost 50 basis points overnight - the biggest one-day move since 2012, at the height of the Eurozone crisis.
  • When European markets opened a short time ago, Italian 2-year bond yields continued to rocket higher, climbing by another 70 basis points. They are now sitting at the highest level since 2013.
  • Demand for safe-haven German bonds is increasing, with the yield on both 2-year and 10-year German debt falling to the lowest level this year.
  • Reflecting capital flows between Europe's periphery and core, the spread between German and Italian 10-year bonds yields has soared to 261 basis points, the highest level in four years.
  • The euro has also come under pressure, dropping below 1.16 against the US dollar for the first time in 2018.
  • Italy's banking index is also getting hosed, down 3.4% at a 13-month low.
Markets do tend to be highly sensitive to euro-exit related developments, so some of Tuesday's moves may be a knee jerk reaction, but it certainly feels like a crisis is now brewing both politically and economically.
Analysts at Australian investment bank Macquarie, however, urged calm for the time being.

"While we see near term market pressure, we do not think that events today are sufficient to derail the economic recovery (activity has been desensitised to political shocks in the past decade), suggesting that markets will soon present a buying opportunity," a team led by Ric Deverell wrote.

However, Deverell and co. were clear that things could escalate. "A victory for the populist parties in a new election, while far from assured, could trigger a substantial risk-off event," they wrote.