Italian instability points to broader political uncertainty across Europe

The fast-moving political developments in Italy have pushed the country into the spotlight, but in Brussels the drama has come as no surprise.

Ever since the inconclusive Italian general election in Feb- ruary, the political situation in the euro zone’s third largest economy has been a worry.

The results of that election – which saw former EU commissioner Mario Monti, leader of Italy's technocratic government, finish in fourth place, and the rise of Beppe Grillo's five-star movement – was a blow to European hopes that Italy was on the road to reform and committed to continuing tough fiscal consolidation measures prescribed by Monti.

The formation of a fragile coalition government two months later, led by Enrico Letta of the centre-left Democratic party, gave little hope of long-term political stability.

This concern encapsulates a broader anxiety at an EU level about political instability. The euro zone crisis has moved into a new phase. Thanks in part to the European Central Bank’s commitment 14 months ago to do “whatever it takes” to preserve the euro, the threat of a sovereign default or Greek exit has receded and bond yields have settled.

Two issues now preoccupy politicians. First is concern about medium-term economic growth. Although the euro zone officially moved out of recession in the second quarter, record unemployment and concerns about the health of the European banking system continue to weigh on outlook.

Second is the threat of political uncertainty, with EU officials concerned that a government collapse in a euro zone member state could reignite market jitters.

Italy is not the only country to be beset by political tensions.

Greece has been forced to assemble a government consisting of diametrically opposed parties. The country – which has witnessed a rise in inter-party tensions following the unprecedented move by the government to outlaw the neo- Nazi Golden Dawn party – seems on the brink of perpetual collapse as prime minister Antonio Samaras battles to keep the government together.

Corruption scandal
Other countries have seen government authority weaken. In Spain, a corruption scandal surrounding prime minister Mariano Rajoy reared its head during the summer, threatening government destabilisation.

Meanwhile in Portugal, the resignation of two senior ministers in July also left the Portuguese government on the brink of collapse. While the political crisis was defused, local elections last Sunday resulted in a major fall in support for the coalition as voters protested against its tough economic policies.

Government fragility across Europe reflects the deep political challenges involved in implementing stiff fiscal demands prescribed by Brussels on increasingly weary electorates. Coalition tensions over budgetary decisions characterise the continent's many collation formations, from Italy to Ireland.

Government cohesion is likely to come particularly under pressure in the run-up to October 15th when each euro zone member state, including Ireland, must submit its national budget to the European Commission for authorisation. France and Spain have already published their draft budgets for this year ahead of the mid-October deadline.

The ceding of power to Brussels over national budgetary measures represents a shift in the dynamics of the European Union, which has always seen budgetary measures as sovereign. The more pressing worry is that it will ignite tensions between national capitals and Brussels as governments try to get their budgets through parliaments.

Nonetheless, some commentators have noted that market reaction to political instability is not as extreme as expected.

While short-term market jitters have accompanied the various moments of political crisis – Italian bond yields rose on Monday morning following weekend events in Italy – mar- kets are calmer than a year ago.

Political impasse
The real threat posed by political instability is the fear that a political impasse in any member state could delay much-needed structural economic reforms both at a national and EU level.

Already there are concerns that the process of government- formation in Germany could delay progress on banking union. The EU is under pressure to secure agreement on a number of aspects of the complex set of proposals before the term of the current commission ends next summer following European elections.

With the ECB and European Banking Authority set to begin bank stress testing next year in preparation for the ECB taking over direct supervision of 130 of the euro zone's main banks, progress on banking union is seen by analysts as essential for financial stability in Europe.

The fear of a euro break-up may no longer trouble markets, but the prospect that EU leaders are not prepared to take the difficult decisions necessary for structural reform could threaten long-term economic recovery.