Miscalculation

Warren Buffet, commenting on the current US government shutdown and the looming issue of raising the debt ceiling, suggested that the Obama administration together with the Congress will, over the next few weeks, walk right up to the line of "extreme idiocy", but, as before, not cross it.

Seems the Italian coalition government, having reached its own line of extreme idiocy yesterday, did just as Mr. Buffet predicted - it didn't cross it. Italian Prime Minister Enrico Letta yesterday won a vote of confidence in the Senate, a vote he himself instigated - this after a last-minute U-turn by PDL leader Silvio Berlusconi who had, over the past weekend, moved to topple the government by instructing his five ministers in Prime Minister Letta's ruling coalition to withdraw. Reports surfaced immediately after the Berlusconi directive, however, that his plan to bring down the government was beginning to unravel. The five PDL Ministers were resisting. Then, yesterday, in the Senate, certain hard-line Berlusconi supporters refused to go along - the first revolt ever in PDL history - instead voting in favor of Letta's coalition. In announcing his abrupt shift, and in a rare moment of understatement, Berlusconi rose in the Senate and said, "Italy needs a government that can produce structural and institutional reforms. We have decided, not without internal travail, to back the confidence vote". By 235 votes to 70, Enrico Letta's coalition survived. Stocks on the Milan exchange jumped, and bond yields dropped.

This time, Berlusconi has badly overreached himself, clearly miscalculating support from within his own party. It is now reasonable to suggest that he is at or very near the end of his two decades of political life, during which he dominated Italian politics despite legal challenges and sex scandals. On Friday, the Senate will vote on whether to strip him of his seat following his conviction for tax fraud. The conviction will require him to serve a one-year sentence, likely under house arrest or via community service (given his age). Even worse is likely: he is appealing a conviction for paying for sex with a 17-year-old prostitute; if he loses, the sentence is seven years in jail.

Few European leaders, particularly in Brussels and Berlin, will lament the demise of Berlusconi's political influence. In his absence, Italian politics will simply be better. But the fundamental challenge remains: unless this government can can make big reforms, the economy will remain in recession, and the ability to reduce and finance the country's huge public debt (estimated at 130% of GDP) will remain problematic, even with the European Central Bank's backstop pledge to cap borrowing costs.  

Coalitions

Angela Merkel, having won a third term last weekend as Chancellor of Germany, but not a majority of seats in the Bundestag, is now busily negotiating with parties of the center-left to form a governing coalition, a process that could take weeks. In her role as de facto leader of Europe, however, this may not be the only coalition with which she needs to concern herself.

Italian Prime Minister Enrico Letta was forced to return - abruptly and embarrassingly - to Italy last week from the UN General Assembly meeting in New York. (He was, among other things, courting investors desperately needed to continue the financing of Italy's massive public debt.) Seems Silvio Berlusconi's center-right party (PDL) was once again threatening to pull out of the fragile coalition government, formed with Letta's center-left party (PD) after last February's deadlocked parliamentary elections. Berlusconi, convicted of, among other things, tax fraud, may be stripped of his seat in the upper house at a special Senate committee meeting on October 4, and if this occurs, PDL members have indicated they will walk out en masse in protest. Already, Berlusconi has ordered his five Ministers to resign from the government, in apparent protest against a planned increase in sales tax, part of broader government policy to reign in the public debt. Prime Minister Letta has called this Berlusconi-inspired reasoning a "huge lie", strong language, especially for Mr. Letta. Unless the 88-year-old President Napolitano can once again bring together the various political factions - as he did masterfully last April - Italy's 64th government since WWII will collapse next week following a scheduled confidence vote.   

The long process of fixing Italy may thus be put on hold, again. The immediate concern is that Italy faces another downgrade of its government debt; the Milan bourse dropped last week, and borrowing costs on benchmark 10-year bonds rose on Friday to their highest level since the beginning of the summer. But the more fundamental, pan-European concern is that, as the difficult political haggling continues in Berlin to establish a stable governing coalition for Germany, and as governments in Greece, Spain, Portugal and Hungary face the on-going challenges of restoring stability, another political impasse in Italy, with an accompanying economic implosion, could at the very least render considerable pressure on the euro, testing the resolve of the European Central Bank.

Reports of the demise of the European crisis are, thus, greatly exaggerated. 

"Mutti" Wins a Third Term

Of the eight German Chancellors of the Federal Republic of Germany (FDR), the political entity which came into existence in 1949 and reunited with East Germany in 1990, Chancellor Angela Merkel (referred to affectionately as "mutti", or "mother" in English, by the German people) is currently the fourth longest-serving in that office. With her victory in last Sunday's federal election, she is on track to become the third longest-serving, after Helmut Kohl from 1982-1998 and Konrad Adenauer from 1949 to 1963. Such stability can only be welcomed in an otherwise volatile European political and economic environment; Merkel herself was quick to announce immediately following the election that "our European policy course will not change".

But while the election results give Mrs. Merkel a few more years as Chancellor, and the European continent some continued certainty at its center, the next few weeks in the FDR will nonetheless be marked by intense horse-trading as the country's politicians work to form the next coalition government. The FDR has a parliamentary political structure, requiring either a majority or, in its absence, a coalition of two or more parties, for effective rule. As Merkel's conservative CDU/CSU bloc received only 41.4% of Sunday's vote, she must find a coalition partner to form a new government. Her former partner, the Free Democratic Party (FDP), failed to win even enough support to exceed the 5% threshold necessary to send legislators to parliament. Politically, this was a complete collapse of the FDP party, and leader Philipp Roesler has resigned.

Mrs. Merkel's remaining coalition options are problematic. The next largest party after Sunday's elections, the centre-left Social Democratic Party (SPD) , had earlier stated that it would not join the CDU, with whom it was in a "grand coalition" government before the 2009 election. This experience left the SPD feeling very much the junior partner, and cost the party significant electoral support from its more left-leaning members. And the SPD is on record for vehemently opposing Mrs. Merkel's policies of austerity for EU partners in southern Europe, notably Greece, Spain and Italy. Another possible combination would be a CDU link with the Green Party, which won 8.5% of the vote, but this would be, to say the least, an odd right-left coming together.

So the German political scramble is on. Europe can only trust and hope that it in no way resembles what occurs regularly in Germany's southern neighbor, Italy. In any case, the election confirms that Chancellor Merkel is easily Europe's dominant politician. With an eye now on her own legacy, she may even become a little less incremental - bolder - as she addresses domestic and European policy challenges.

Another Graduate

Yet another central bank is now being governed by a PHD graduate (in Management) from MIT. Raghuram Rajan, a former chief economist at the International Monetary Fund, this month became the 23rd Governor of the Reserve Bank of India, that country's central bank. (Two other current world central bankers are also MIT PHD graduates - Fed Chairman Ben Bernanke, who graduated in 1979, and European Central Bank Governor Mario Draghi, who graduated in 1977.)

Just as Chairman Bernanke surprised markets on Wednesday by doing nothing, so has Governor Rajan, by doing something not just unexpected but, in his very first monetary action, bold as well. He announced today an increase in the repurchase rate of a quarter point, to 7.5%,, despite an Indian economy that is exhibiting the weakest growth since 2009 (estimated at some 4% this year compared to the past decade's annual average of 8%), and even after the Fed's decision this week to continue monetary stimulus had already eased pressure on the rupee, which had been plunging since May. By raising rates, Governor Rajan has a single purpose - to send a clear signal that he intends to reign in the 9.6% consumer-price inflation that has continued to accelerate. The Governor is only too well aware that India is facing a full-blown balance of payments crisis; its current account deficit is one of the highest in the world, the equivalent of 4.5% of its GDP, and capital flight is exacerbating its financing. The country's budget deficit is similarly huge, amounting to some 5% of GDP. Countless times, in many countries, over many years, this has typically been the point at which the IMF has to be summoned for an emergency bail-out loan that is accompanied by a package of austerity measures.

So, like his fellow MIT alumni in Washington and Frankfurt, India's new central bank governor will have a busy schedule over the next several months. Another hike in interest rates may be required, especially since Prime Minister Singh's government, hobbled by graft scandals and facing re-election in May 2014, may be unwilling to introduce supportive fiscal measures to reduce the budget deficit. Governor Rajan's announcement today is having its intended effect; the rupee is stabilizing, albeit at a nearly all-time low of 62 to the US dollar, compared with 55 a year ago and 45 a decade ago.

No doubt the Governor will be consulting, at least privately, with his MIT alumni Governors as he works to right an economy gone very wrong.  

The Gloves Come Out Again

Fed Chairman Bernanke surprised almost everyone yesterday by not tapering, even a little. The pace at which the Fed is currently supporting the US economy, by printing money to buy bonds and thereby lower interest rates (so-called quantitative easing), at a rate of $85 billion a month, is to continue. This despite earlier Fed pronouncements, especially in June, when taper talk began, the result of which over the summer has been a dramatic tightening in financial markets. Yields on 10-year treasury bonds have risen by almost a full percentage point in America - the biggest one-time jump in decades - just on the prospect of the onset of tapering, and the effect has been global, with yields even in Europe rising and emerging-market currencies plunging.

The Fed cited growth that is less robust than it ought to be at this stage of the recovery, unemployment that although trending down is still too high (that is, above 6.5-7.0%), and underlying inflation pressures that are so tepid they could easily morph into deflation. So tapering, even a modest reduction to say $70-75 billion a month, must wait. A complete cessation of the program now seems months away, at least. Long bond rates dropped yesterday, and equity markets surged, as a result.

Apart from the weak data, however, the Fed was also concerned yesterday, arguably primarily, with another possibility, that is, a looming US federal government shutdown - another showdown between Congress, particularly the Republican House, and the Obama administration, over the debt ceiling. Seems the Fed concern was well-placed. The debt ceiling must be raised again, as it has been periodically for decades, by early next month, by Congressional legislation. If it isn't, the federal government technically defaults on its outstanding debt. (The delay in raising the debt ceiling in 2011 resulted in the first downgrade in the US credit rating, a sharp drop in the stock market, and an increase in borrowing costs.) President Obama has made clear in recent days that he will not negotiate the "technical necessity" of raising the level again. Republicans in the House, however, have a different view - Speaker Boehner announced today, tersely and bluntly, that America's debt level, now close to $17 trillion, or nearly 80% of GNP, must stop rising. The Speaker wondered aloud why the President would, for example, negotiate with Putin over Syria, but not with Congress over such a critical domestic economic concern. And to make the Republican position perfectly clear, Boehner has scheduled a vote for Friday on a bill that would condition a stopgap spending measure on support for de-funding ObamaCare. "We'll deliver a big victory in the House tomorrow and then this fight will move over to the Senate where it belongs," the Speaker said today. "I expect my Senate colleagues to be up for the battle."

So once again, the gloves are on and the tension ratchets up in Washington. Just as well that the Fed, responsible for monetary policy, but in recent years forced to be ever more mindful of Capital politics as well, decided to delay even the slightest bit of policy tightening.