Three options for Italy

Editor's Note: Christopher Alessi is an associate staff writer at CFR.org. This is an Analysis Brief, reprinted with the permission of the Council on Foreign Relations. The views expressed in this article are solely those of Christopher Alessi.

By Christopher Alessi, CFR.org

Italian Prime Minister Silvio Berlusconi agreed to resign (LAT) after parliament passes new budgetary measures for 2012 meant to tackle Italy's mounting public debt. Berlusconi's decision came after he lost his parliamentary majority and a critical coalition ally publicly called on him to step down. Nonetheless, yields on ten-year government bonds reached a euro-era high of 7.4 percent (NYT) on Wednesday, signaling a continuing lack of market confidence in Berlusconi's ability to pass needed austerity measures and fend off eurozone sovereign debt contagion.

What's at Stake

The European Financial Stability Facility (EFSF)–set to be leveraged to $1.4 trillion as part of a comprehensive euro rescue plan (BBC) agreed on last month–does not have the means to finance Italy's $2.6 trillion debt. Greece, Ireland, and Portugal all sought financial rescue packages when their respective government bond yields breached 7 percent–a level markets consider unsustainable for a country to borrow money on private markets. Therefore, if Italian leaders are unable to muster the political will to rein in public debt through strict austerity measures, a default could be imminent.

The repercussions of such an event could damage the eurozone's core and devastate Europe's highly exposed financial system. At the end of June, EU banks held just under $344 billion in Italian government bonds. If investors had to take losses on their Italian debt, it could trigger a run on Italian banks (DerSpiegel), creating knock-on effects for the global economy.

The Debate

Italy has been at risk of sovereign debt contagion not just because of its economic troubles, but also because of a dysfunctional political culture. Analysis in the Italian press suggests that with Berlusconi's decision to resign, three different scenarios could play out.

Berlusconi could call for fresh elections next year and stay on until then, the option least convincing to markets but the most probable. Secondly, he could allow for the formation of a new government, led by one of his center-right allies, which would theoretically be able to muster support from some smaller centrist parties that had refused to support Berlusconi directly. Thirdly, Berlusconi could sanction a more technocratic government–led by a candidate who has support from the center-left–that would have a mandate to pass the strict budgetary measures.

The latter is favored by market actors. The prime minister's immediate resignation and formation of a technocratic government would lead to a "favorable reassessment of Italy in the minds of international investors," Nicholas Spiro, head of Spiro Sovereign Strategy, told Reuters.

Policy Options

While Italian public debt is a staggering 120 percent of GDP, the economy is strong in other ways: It has a relatively low budget deficit–4 percent of GDP–and a high private savings rate. "Italy has the resources to draw on," Domenico Lombardi, director of the Oxford Institute for Economic Policy, told CFR.org. The IMF, the European Central Bank, and an enlarged EFSF could offer Italy bridging assistance by providing access to financing while it addresses its debt problems.

But those organizations are waiting for Italy to make the first move, Lombardi says. The EU and the IMF are holding the Italians' feet to the fire to see if they have the political will to implement pension reform, more flexible labor laws, and restrained government spending.