Monti’s Resignation: The Bark And Bite Of Austerity And Political Uncertainty

Italy is back in the spotlight.

Italy’s Prime Minister Monti has promised to resign, at the latest once the governments’ 2013 budget passes into law. The budget in question includes further austerity measures for Italy, after the country has already imposed tax increases and spending cuts over the past year. Monti’s resignation and potential failure for the budget to pass underscore that the mood toward austerity in Europe is changing, as politicians and bureaucrats increasingly argue that austerity may have gone too far.

It is not surprising that sovereign bond yields have moved higher because the resignation injects new uncertainty into the European political landscape. Recall that since the announcement of the ECB’s OMT program in September, periphery bond yields have melted, in part because the program is conditional on the country in question first seeking an international bailout. Imposing this conditionality means that there is a greater chance that structural reforms would be made in a country that relies on ECB purchases.

The bond market reaction to Monti’s resignation announcement underscores that the political risk premium in Europe has not been eliminated. Nonetheless, the OMT ‘backstop’ is still in place: any flare up in periphery bond yields should remain muted relative to the experience of the past few years.

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