Italian voters, though not handing outright victory to any particular party, did reject austerity at the polls, a measure that is at the heart of the Eurozone's efforts to curb national debts and ensure the continued existence of the euro. That policy could be nearing a reality check.
Most investors and traders take it for granted that the euro has been saved thanks to the commitment by the European Central Bank (ECB) to do “what it ever it takes.” But as the results of the Italian polls show, voters in peripheral Eurozone states are growing tired of austerity and are rebelling against it.
That could pose a very real dilemma for the ECB at some point, possibly even quite soon depending on the final shape of Italy's political landscape. A key component of doing whatever it takes is the ECB's Outright Monetary Transactions (OMT) programme, which involves buying the bonds of a Eurozone state facing financial distress to drive down the cost of its debt. However, that comes with strings attached, such as implementing increasingly unpopular austerity measures.
The OMT conditions are designed to avoid a situation where the ECB effectively ends up creating new money to finance a government, which would be considered monetary heresy in Germany, a country deeply scarred by the antics of the Weimar republic in the 1920s with its money printing, which led to hyper-inflation.
EUR/USD chart – Ground-hog day for the Euro
But what if voters in Italy, or even another peripheral Eurozone country, actually voted in a party on the basis of rejecting austerity and economic reforms?
That likely would lead to credit downgrades and for the yields on the bonds of that country to balloon putting it in a situation where they no longer could fund themselves. In the case of Italy that would be particularly serious given it is the third largest debtor country in the world and that poses a massive systemic risk to Europe's banking system, and by extension the global one.
Also, it might be dangerous for an institution such as the ECB to override the democratic mandate of an elected government. It would very likely cause deep revulsion toward the Eurozone by the people of that country and spur even more extreme political parties and anti-EU sentiment.
Given those risks, the ECB very likely would have to find a way to support the bond market of that country, possibly indirectly such as funding purchases by commercial banks. However, it has not reached that stage — yet.
The take away is that any election in a peripheral Eurozone country risks triggering a sell-off of the euro. The depression in many peripheral Eurozone economies combined with social cohesion unravelling could see unstable governments leading to more frequent elections and the rise of extremist anti-European parties.
Leaps in Eurozone integration usually come about as a result of crises; however, the abandonment of austerity in the peripheral Eurozone combined with the prospect of outright money printing by the ECB could prove one crisis too far. Alternatively, the Eurozone could adopt a pro-growth strategy, involving ECB support, but that would mean getting Germans on board, which would be very difficult.