• Mistrust. The debt crisis drags on! Investors were increasingly doubting the ability of policymakers to resolve the problems. The euro plummeted, while risk premiums of periphery countries skyrocketed. Even the announcements that Berlusconi & Papandreou would resign did not help – with investors waiting for Berlusconi to literally leave office.

• Exuberance. Markets targeted primarily Italy this week, driving government bond yields to an interim record high 71?2% (a level that already saw Greece, Portugal and Ireland seek bailouts). We, however, think that this is excessive. The fears reflect neither fundamentals nor reform efforts.

• Italy's public debt is undoubtedly high, GDP growth low, and structural deficiencies numerous. But Italy’s budget already shows a primary surplus. Furthermore, the sweeping restructuring and reform measures will presumably pass parliament tomorrow. And in the past, Italy has demonstrated that it can bear a much heavier interest rate burden (see chart) than that looming for the coming years, even with higher yields.

• Politics. The passage of the Stability Act will also clear the way for a political “new beginning” in Italy – most probably with an interim government headed by the former EU Commissioner Mario Monti. The appointment of former ECB Vice-President Papademos as interim prime minister should also ensure implementation of the Greek restructuring package (pages 2-3). Both should help to stabilize markets.

• Promises. This week, the French government went one step further to ensure the planned deficit reductions (pages 4-5). And when elections are held in Spain in just over a week, the new conservative government should press ahead with austerity measures and structural reforms, too.

Political events in the Southern Periphery

What an eventful week we had on the political front! Unprecedented political and market pressures delivered changes to the political landscape that we would have considered hardly possible only a short while ago. In Greece, Papandreou stepped down to allow the setting up of a transitional coalition government led by former ECB Vice-President Lucas Papademos. In Italy, we are also getting closer to a technical government, with former EU Commissioner Mario Monti being considered the leading candidate for the job of prime minister. Given the strong credentials of these two personalities, these latest events promise to bring some fresh air into politics and reinforce the credibility of the countries’ commitment to pursue the pledged reform path. In Spain, the electoral campaign officially kicked off. Here the hope was that a sound political debate about the real difficulties that confront the country will get the upper hand versus old electioneering practices. Unfortunately, the tone of the debate has so far failed to impress. We assess the most recent developments in the following.

On Greece – On Thursday (10 November), the main political parties eventually reached an agreement on the transitional coalition government and named former ECB Vice-President Papademos as the new prime minister. A statement from President Papoulias firmly stated that the priority of new government would be to adopt and implement the 26 October bail-out agreement.

The name of Papademos has been circulating for a while, but each time it was “turned down” in favor of a less prominent candidate. Two elements explain why it took politicians so long to reach a consensus on the ex-central banker’s name. First of all, Papademos has allegedly made several stringent demands before accepting the job. These reportedly included a formal commitment by the main political leaders to honor the agreements made on 26 October, the participation of a larger number of politicians from the opposition New Democracy (ND) in the new coalition, and the postponement of general elections, tentatively scheduled on 19 February. ND leader Samaras had firmly refused to sign any promissory note along the lines asked by Papademos, restating his view that the composition of the austerity package need to be reconsidered, and he also objected to any delay of the general elections. Second, incumbent Finance Minister Venizelos strongly opposed the nomination of Papademos for fear of being marginalized or being forced to leave the government. At a certain point, his name seemed to have become the favorite for the post, but some PASOK members possibly had not forgiven him for the attempt to sidestep his role (Venizelos engaged himself in negotiations with parties to form a coalition government without having obtained a mandate).

Shortly after his nomination, in a broadcasting appearance Papademos addressed the nation, calling on all citizens to participate in the process of adjusting the economy and implementing the aid program, which he acknowledged was critical to Greece’s future. He hinted that he had obtained the assurances he was looking for in order to accept the post, and so he will be able to fulfill his job without any political interference. Specifically, he said that, at this stage, there is no specific date for new elections, and hence no timeframe for the new transition government, stressing that the date of 19 February should be considered only as a “reference point”. He also commented that the new government will have broader political support than the previous government.

Overall, he conveyed a message of optimism about the possibility of overcoming the sizeable challenges ahead and reassured the Greek people that euro membership is a guarantee of monetary stability and will help ease the adjustment task. We can only applaud this attitude, as we think that at this delicate juncture the Greek people need to hear (and trust) that their sacrifices will be eventually rewarded.

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