With no party having gained sufficient seats in the upper house of the Italian legislature, analysts warned on February 25, 2013 of a “hung parliament,” which would make it even more difficult for structural and fiscal reforms to be passed. Even though the Democratic Party appeared to have gained a slim victory in the lower house, giving that party the majority of 340 seats out of 630, the upper and lower houses have equal law-making ability so even the possibility of a hung parliament roiled markets. I contend that this is yet another case of financial analysts over-reacting to political uncertainty.
“It was the worst possible outcome, feared by market participants and European policy-makers alike. Italy is facing Greek-style political gridlock and possibly new elections,” Tobias Blattner said at Daiwa Capital Markets.[1] The Wall Street Journal observed at the time, “Italy’s growth prospects are tepid at best, and the election result demonstrates in spades that its fractious politics has not been masters.”[2] Generally speaking, the parties protesting the fiscal reforms demanded by the E.U. did well, suggesting that Italy could find itself at odds with the federal government in how to resolve the state’s debt crisis.
Italy’s bench market index, the FTSE MIB, traded down 4.62 percent on February 26th and the euro sank close to a seven-week low against the dollar, trading at $1.31. Yields on 10-year Italian bonds jumped 0.45 percentage point to 4.81 percent. Bonds of Spain, Portugal and Greece were hit too. In America, the Dow fell nearly 300 points on February 25th, the market’s worst day in almost four months. Markets in the E.U. were down around 2 percent, but futures indexes there and in the U.S. were up the following day.[3]
The optimistic showing of the futures indexes on the day after the election hints that the market on both sides of the Atlantic over-reacted to the anticipated gridlock and possible new election. To an extent, the results are within the range of what can be expected from a multi-party system of parliamentary democracy. Indeed, the states of Britain and Germany had had to form coalition governments just a few years before, and even the problematic Greek elections ended with a government. In fact, that government ended up ratifying the additional austerity.
Moreover, the immediate reaction of the markets seems antiquated to me in the sense that market participants had not adjusted their mindsets to the contemporary European context. In particular, the participants treated Italy as though it were a sovereign state, rather than a state in the E.U. There being a federal level mitigates the importance of state elections even though the states hold more power in the E.U. than the American states hold in the United States. Put another way, the E.U. would surely pressure Italian officials to end the gridlock. Even if the resulting state government were antagonistic to the austerity approach, negotiations would doubtless occur between the state and federal levels. The result would not be as stark or extreme as perhaps market participants presumed in their immediate reactions to the news.
Moreover, such overreactions to political instability may also be due to a projection of relative business certainty onto political turf, which is inherently uncertain even though engrained institutions and constitutions can buffer the turbulence as political dynamics naturally shift and even erupt. Business analysts and investors used to being able to hedge financial and market risk inhabit the business world, which generally does not produce such instability as does the world of politics. In other words, a legislature is generally more rambunctious than is a corporate board meeting. Uncertainty is even in just looking at that other world, as it is so different. This uncertainty, plus novice judgement in political affairs, can explain why political risk analysis may overstate political uncertainty even though it is more than business uncertainty.
1. Charles Forelle, “Italian Election Outcome Sparks Selloff,” The Wall Street Journal, February 26, 2013.
2. Ibid.
3. Alessandra Galloni and Giada Zampano, “Messy Italian Election Shakes World Markets,” Febraury 26, 2013; Katy Barnato, “US Stock Futures Rebound; Italy, Bernanke in Focus,” cnbc.com, February 26, 2013.
