Italian political deadlock casts new uncertainty on eurozone recovery

Markets tumbled and the value of the euro dropped in response to Italy's election results and their unexpectedly loud rejection of German-imposed austerity policies.

Europe’s murky path to recovery was rattled yet again Tuesday as markets and policymakers tried to digest the unexpected Italian electoral results and the consequences, especially on periphery economies.

A political stalemate in Rome all but condemns the country to new elections in less than a year, with all the implications for the economy. But the unexpectedly loud rejection of German-imposed austerity policies fueled market uncertainty over the already wobbly resolve of European governments to stick to fiscal conservative recipes.

Markets were stunned by voter rejection of Prime Minister Mario Monti’s austerity and by the triumph of the Five Star Movement, the anti-establishment party led by comedian Beppe Grillo that won the most votes of any single party.

The austerity versus growth debate is not new to Europe. The battle of wills pitting Germany and its northern European rich allies against the French-led periphery, including Italy and Spain, has been raging from the beginning. In fact, it’s precisely this lack of consensus that has delayed the recovery.

While 2013 is supposed to mark the beginning of the end to the bloc’s worst economic crisis since its creation, an anti-austerity voter rebellion in Italy could yet again undermine the fragile consensus and discipline around common European economic recovery policies, which so far have been imposed by austerity-driven Germany. Chancellor Angela Merkel also faces elections this year.

Growth vs austerity

The cost of borrowing for the infamous PIIGS (Portugal, Italy, Ireland, Greece, and Spain) climbed today, peaking at their highest levels since last December’s previous uncertainty bout before dropping slightly. The euro also collapsed to almost its lowest level of the year, while European equity markets tumbled, despite the gains on Wall Street.

The biggest concerns lie in Italy and Spain, the third- and fourth-largest economies of the 17-member eurozone. The economic picture is dire, but the main risk to recovery remains political.

Investors worry about the Italian economy after the hung election all but ruled out any major new policies to reduce the government deficit and boost growth, dragging the broader European economy.

“It is difficult to envision a grand coalition or a hodgepodge minority government making any meaningful progress on structural reforms,” political risk consultancy Eurasia Group wrote in a note. New elections will likely be held “within the next 6-12 months.”

But mainstream parties are worried about shedding even more voter support following the unexpected gains of the Five Star Movement. “An immediate return to the polls would only swell support for Grillo, as this would demonstrate the weakness and incompetence of the mainstream political parties,” Eurasia Group wrote.

The Spain equation

In Spain, the government has been facing intense pressure over its austerity policies, and even if there are no forthcoming elections, its ability to continue trimming the deficit is increasingly threatened by social unrest and by internal political wars and corruption scandals that are weakening governability.

If the cost of borrowing continues increasing for Spain, even if it’s an indirect result of Italian or German internal politics, the country could be forced to request a bailout that could further undermine the eurozone’s economy if investors conclude the risk of political instability outweighs the timid economic progress so far.

But ultimately, Europe is simply going to drag its recovery until the ongoing debate over austerity versus growth is resolved, either by politicians or voters.