Silvio Berlusconi's Circus Is Back in Town

The political antics of Italy's former prime minister could hurt the whole eurozone.

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People of Freedom party leader Silvio Berlusconi wipes his face at the Senate, in Rome, Wednesday, Oct. 2, 2013. Italian premier Enrico Letta was putting his government's survival to confidence votes in Parliament on Wednesday amid a divisive split in Silvio Berlusconi's party that could at least temporarily save his fragile ruling coalition.

The Italian soap opera is taking a dangerous turn, and Silvio Berlusconi is at the center of it all again. Berlusconi, in an attempt to escape the ramifications of his own conviction for tax fraud, threatened to bring down the Italian government on September 28 when he instructed five government ministers from his People of Freedom party to resign. Many believe Berlusconi manufactured a crisis to derail the potential shame of being thrown out of the Senate by a special committee that is currently convening.

After Berlusconi's maneuver, the new and fragile coalition government of Prime Minister Enrico Letta faced a confidence vote in the Senate. The Letta government won with 235 votes to 70, showing that this was an unnecessary vote of no confidence. This time,  Berlusconi seriously miscalculated. His own senior party members rebelled against his call to throw the Italian government into bedlam. One of the key senior party members to push back against Berlusconi was Italy's Deputy Prime Minister, Angelino Alfano, who is known as a staunch Berlusconi loyalist. Berlusconi had to backtrack. The upside is that this is a sure sign that Berlusconi is losing control over his own conservative party, especially a personal veto over Letta's government.

The danger of all this Italian drama, however, is real. The danger is not only to Italy (the third largest economy in the eurozone) but to the eurozone member states, and eventually even to U.S. markets and growth. Just look at some of the key Italian economic concerns: Italian gross domestic product per capita has shrunk over the last decade; its economic growth rates for 2012 and 2013 have contracted; it has an aging population; despite past budget cuts, additional serious austerity measures have yet to be taken to curtail the 130 percent debt to GDP, second highest only to Greece; and unemployment is over 12 percent. In addition, Italy has immigration issues and an increasing loss of global competitiveness in its industries.

[See a collection of political cartoons on the European debt crisis.]

Berlusconi's contribution does not help the already highly charged Italian political arena. The markets might get the impression that things are spiraling out of control and that Italy is truly ungovernable. If this suddenly turns into markets losing faith in Italy's future solvency, a crisis of confidence (i.e. panic) may occur with a very contagious infection in the eurozone.

The risk is that Italy and Spain may begin to look alike to investors. The repercussions could be a liquidity crisis in Italy, throwing the eurozone off tilt again, not to mention the U.S. markets taking a hit. Herein lies the real danger of Berlusconi's personal antics.

I have said this before: Italy is too big to save easily, as it has the world's third largest bond market. The European Central Bank keeps Italy and Spain's borrowing costs low by buying Spanish and Italian bonds. The question is if there is a full blown investor panic, can the ECB continue to keep up with the monetary demand for liquidity for both Spain and Italy? And if so, for how long?

The ECB's unlimited liquidity support for Spain in a crisis is one thing, but a liquidity crisis in the world's third largest bond market is quite another. If the liquidity problem in Italy turns into an Italian solvency problem, then we all have a problem. Despite anticipated market volatility over the next few weeks as things calm down in Italy, so far we seem safe because markets are choosing to focus on eurozone recovery data.

If Berlusconi, however, continues to drag the Italian government's credibility down, Italy might end up losing "fiscal credibility" and then monetary (i.e. country credit rating downgrade) credibility. The day of reckoning will be when the markets decide to focus on some of the other key Italian economic concerns mentioned above and not Berlusconi.

Scheherazade Rehman is a professor of international finance/business and international affairs at the George Washington University. You can visit her homepage here and follow her on Twitter @Prof_Rehman.

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