Rome Returns

Audrey Hepburn in Roman Holiday

There has been a watershed in Europe even if the debt crisis remains unresolved. Since Monti became the technocrat prime minister of Italy an important change taken place. Simply put, Italy has taken significant steps away from the abyss.

Part of the rise of Italy under Monti is a function of how far it had slipped under Berlusconi. Another aspect of Italy's improvement is a function of the Monti's fellow countryman Draghi, who at the helm of the ECB has reversed Trichet's tightening and accelerated the expansion of the ECB's balance sheet with 3-year funding.

There is another development that has benefited Italy. The Financial Times captured this last week when it reported a "growing opinion that economic fundamentals in Italy are better than in Spain." Indeed, Italy's star has risen as Spain's star has dimmed, but also as the domestic challenges Sarkozy face, take him a bit out of play, so to speak.

Yet Monti deserves some credit a well. His reform agenda combines austerity in the form of tax increases and spending cuts with pro-growth measures. His labor reform efforts need parliamentary approval, ideally by the end of next month to solidify his success.

Monti has carved out a position in European high politics that is unique. Sarkozy and Merkel may have their own reasons for trying to use Monti to further their own agendas, but Monti has his own. He may be the only senior official in Europe to be able to criticize Germany and France for their own fiscal lapses and dilution of the enforcement provisions of the Stability and Growth Pact.

The markets have rewarded Italy. Since Monti's arrival the 10-year yield has fallen from the 7% threshold to around 5.5%. This is yield area that prevailed in late Q3 11 before the flare up in pressures that led to Berlucsoni's departure. The 5-year CDS has fallen from 575 bp to about almost 400 bp.

The premium Italy pays over Spain has fallen considerably. At the peak it was near 200 bp. Today it is about 30. The cost of insuring Italy is only now marginally more than Spain (20 bp). The gap was over 100 bp at the end of last year.

The premium Italy pays over Germany has narrowed considerably as well. This is due almost exclusively to the decline in Italian yields.

After Monti took office we suggested that in order for him to help restore confidence Monti would have to sacrifice some sacred cows. Fostering entrepeneurialism and profit-seeking behavior instead of rewarding rent seeker would antagonize entrenched interests. We suggested that taxing the largest property owner in Italy was not only equitable but economically necessary.

Monti has moved in this direction. This week he has indicated to the European Commission his intention to submit such a bill to parliament. He is proposing taxing the Church's property used for commercial purposes. Moreover, the commercial purposes are broadly understood to be not just "exclusive" but "prevalent" as well. A municipal government association in Italy estimates the tax can raise 650 mln to 2.6 bln euros annually.

To be sure, the progress Italy is making can be reversed. Monti is an unelected prime minister. His term will end in a year. He may be enjoying a bit of a honeymoon. Domestic opposition has been quietly biding its time, but as elections draw near there is no reason to expect this to persist.

In addition, the economic slump is likely to bite more. The economic slump deepened in H2 11, with Q3 contracting 0.2% and Q4 contracting 0.7%. The consensus expects the economy to contract in the first two quarters of this year.

The relatively low level of household debt in Italy, the informal economy and the Italian-specific generational transfer (e.g. adult children living with parents) may help blunt some of the macro economic impact.

Italy also remains sensitive to external developments, including the outcome of Greek negotiations and the French election. The next LTRO, with the Italian central bank accepting a wider range of collateral, should continue to bode well for not only sovereign auctions but bank funding as well. Smaller and medium sized institutions are thought to be likely to benefit as well.

If, as some one said, Weber should be credited with helping to save the euro, by resigning and making way for Draghi, then Berlusconi should also be so honored for making room for Monti.