Berlusconi Cuts Deal: Et Tu Brute

Controversial Italian Prime Minister Berlusconi appears to have finally capitulated to international and domestic pressure. Press reports indicate that he has agreed to step down by January. This in turn will bring forward elections, probably to March 2012, a year earlier than Berlusconi had previously insisted.

Italy would join a number of other countries who will go to the polls or in other ways change leadership next year. This includes the US, France, Mexico, China,and Russia. Spain's election initially penciled in for next year has been brought forward to next month. It is possible that the current Greek government collapses, especially if a super-majority is required for passage of reforms that emerge from the EU summit.

It is clear that if one wants the great experiment of monetary union without political union, the contagion cannot really reach Italy. Its stock of debt is such that a modest increase of rates in the primary market (new issuance) is not as ruinous as it may be for lower debt countries in terms average yield and increase in the secondary market.

Increase in yields in the secondary market impact other market participants and sentiment. News that the end of Berlusconi's government is around the corner does not appear to have generated much market reaction. The sovereign CDS is essentially flat on the day.

The generic 10-year yield also essentially unchanged just below 6%. Italian equities are higher. While they seem to be outperforming other major European bourses, they have the dubious honor of sharing with Switzerland the only major European bourse that is over the past five sessions. Italy's Treasury sold 10.5 bln euros of bills and bonds today. Short-term yields are their highest in nearly 3 years.

Berlusconi and his ally/rival Bossi of the Northern League have agreed to send a letter of commitment to the EU before today's summit (though reports suggest no one has received it yet) to raise the retirement age to 67 and other structural reforms. Bossi had as recently as early this week rejected raising the retirement age. The risk is that conventional opinion blames Berlusconi for more than is his due.

Unlike many countries, for example, that have surges in the deficits, the Italian budget deficit is not the main problem, it is Italy's debt, an accumulation of past deficits. It is more a legacy problem. But ultimately even this is only the third of the iceberg that is above the water. The real problem in Italy and other peripheral countries is simply the lack growth and competitiveness.

The opposition to Berlusconi could not bring the government down through numerous confidence votes. Ultimately it was his own coalition that brought him down. As we have seen in countries in the euro zone that have had elections, like Ireland and Portugal, the opposition offers different personalities but not a different program.

How to rekindle growth in Italy does not seem to be understood and investors cannot really be confident that raising retirement ages and making it easier to hire and fire workers is going to resolve anything in the kind of time frame that matters. The recent string of data warns that Italy's economy may contract perhaps as recently as last quarter, but also into next year. This is likely to bring more austerity, and poorer growth and the spiral continues with or without Berlusconi.