Berlusconi Might Hang On Longer Than Markets Think

The Italian prime minister's resignation doesn't translate into a fallen curtain on Europe's debt drama


Italian Prime Minister Silvio Berlusconi may be offering to resign after losing a routine confidence vote in parliament, but his eventual exit doesn't mean the curtain will fall swiftly on Europe's debt drama.

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Stocks soared Tuesday on news of the embattled prime minister's plans to step down, only to plummet today as questions arose over who will lead Italy—and Europe—through the continent's debt crisis. Italy's 10-year bonds also surged past the 7 percent interest rate level Wednesday, a threshold widely considered by traders and investors to be unsustainable over the long term.

According to an agreement between Berlusconi and Italian President Giorgio Napolitano, the current administration will remain in power until Italy's parliament passes new austerity measures demanded by European Union leaders

But the passage of the austerity measures and the formation of a new government could take several days or weeks, according to some experts, who predict increased volatility in the meantime as markets grapple with power shifts and policy moves in Europe. Experts don't expect the required austerity measures will be greeted with open arms by Italy's parliament, which could mean more political deadlock, especially since Berlusconi now lacks a clear majority.

"Berlusconi is not going to be out of the way as quickly and you may be led to think by initial reports," says Adolfo Laurenti, deputy chief economist at Mesirow Financial. "I'm afraid that markets and traders do not understand the Byzantine structure of Italian politics and political institutions. I wouldn't be surprised to see a lot of volatility in the next few days as traders first cheer Berlusconi's departure, then wonder why he is still hanging around."

The earliest Berlusconi would step down would be in a week or so, Laurenti says, but he could hold on until the next election—potentially as soon as January 2012--putting the country in limbo until then, a scenario not likely to be well received by financial markets. [Read analysis of the latest U.S. jobs numbers.]

Italy's progress toward containing its debt problems are widely seen as integral to the euro zone's survival. Currently saddled with around $2.6 trillion in debt, Italy's debts are considered far too substantial for Europe to bail out, especially with the future of the EU's bailout fund, the EFSF, still in question.

High debt levels coupled with increasing borrowing costs will make it more difficult for Italy to roll over its debts and stay current on debt payments.

But even without Berlusconi at the helm, Italy's next government faces the same challenges as Europe tries to salvage the rescue package that many thought would contain the debt crisis in Greece, now licking at the heels of major euro zone economies such as Italy and Spain.

With the future of Italy's government up in the air, there is little outside organizations such as the European Central Bank or International Monetary Fund can do to stabilize the situation. "Until Italy's got a government that the ECB and the IMF can really deal with, it becomes self-fulfilling," says Desmond Lachman, resident fellow at the American Enterprise Institute, referring to Italy's surging borrowing costs over the past few days. "The ECB can't come in and buy bonds to bring [interest rates] down to reasonable levels if it doesn't have a government in place that says they're going to do all the right things for the budget."

Until then, Europe and the rest of the world sit at the edge of their seats. "Italy is a lot more serious than Greece because it's so much bigger and it has so much more debt," Lachman says. "If Italy doesn't do well that really poses a threat to the whole of the Euro experiment."

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