A Guide on Government Gridlock

Gridlock and Italian politics have gone hand in hand lately. Photo by Franco Origlia/Getty Images.

Well, it happened—the US government shut down. The Smithsonian, National Parks and other attractions are closed. The National Zoo’s pandas are offline, and 800,000 “non-essential” federal workers are at home. Congress is supposedly at work, but they’re still deadlocked. As we wrote last week though, the longer-term economic and market impact should be negligible. The shutdown might spark some sentiment-driven volatility, but it shouldn’t have the power to knock the bull market off course—history shows shutdowns aren’t inherently bearish.

Nor is gridlock, despite jitters otherwise—in countries like the US, with competitive economies, it’s bullish! It’s countries like Italy, where lasting recovery likely depends on deep economic and labor market reform, where gridlock is a negative—it keeps reform on ice. Political morass is potentially a big reason Italy hasn’t matched Portugal, Spain and Ireland’s nascent recoveries. The quagmire has worsened lately.

This past weekend Silvio Berlusconi’s People of Freedom (PDL) party pulled support for Prime Minister Enrico Letta’s government. Though the official reason was PDL’s opposition to Letta’s proposed VAT hike, most assume PDL ministers walked in protest of the impending vote to boot Berlusconi from the Senate over his tax fraud conviction—required under a law banning convicted felons from Parliament. Perhaps Berlusconi thinks torpedoing the government buys time to shore up support and ensure PDL wins a snap election (and block his ban from government). However, PDL is polling only slightly ahead of Letta’s Democratic Party and likely won’t be able to form a government given the current election structure.

Whatever the reason for PDL’s gambit, the government’s future is uncertain. Letta has scheduled a confidence vote for October 2, and if he loses, President Giorgio Napolitano could dissolve the government and call snap elections. These likely wouldn’t occur until early next year due to the Constitutional Court’s upcoming ruling on the current electoral system’s legitimacy, expected in December. In the interim, Napolitano could task a temporary government with passing electoral reforms and approving a budget—a more likely scenario, given Napolitano’s stated unwillingness to hold elections while Italy’s byzantine electoral laws remain unchanged.

Either way, it seems safe to say Italy won’t pass meaningful legislation for a while. This isn’t great news for a country with a mile-long to-do list of economic reforms—reforms likely necessary in the long run. Meaningful legislative change requires at least some unity—strong majorities capable of overcoming opposition to politically unpopular measures. Italy doesn’t have this, and without electoral reform, it’s difficult to imagine elections yielding a government with much clout. Thus labor reforms, measures to battle tax evasion and modernization of the energy, insurance, gas, pharmaceutical and postal sectors—just a few of the changes key to helping boost Italy’s economy—likely don’t move forward. Polarizing changes seldom clear divided legislatures.

That’s not to say a continued stalemate is disastrous for Italy, the eurozone or global markets. Italy’s 10-year yield has jumped about 10bps in recent days, but volatility is nowhere near levels seen in 2011-2012. Stalled reform doesn’t mean Italy’s economy can’t or won’t continue stabilizing. Its contraction has slowed in sympathy with the improving eurozone, which likely keeps accelerating with or without a more competitive Italy. Gridlock just means Italy is an unlikely growth engine—more of a growth caboose. Faster growth would likely aid Italian markets, but it isn’t an impediment to global stocks advancing.

Gridlock also prevents big legislative change in the US. But the difference is the US doesn’t need big changes for the economy to keep chugging and even reaccelerate—we already have one of the world’s least restricted economies. In the US, big change is risky. It increases the likelihood of new laws interfering with things like property rights, which markets typically fear. So rather than fear gridlock’s impact on budget negotiations, perhaps investors should see stalled Beltway bickering as a sign Congress can’t do much to disrupt the bull.

Gridlock doesn’t mean nothing happens—it just means radical legislation likely bombs. Compromise on key issues, like funding the government and raising the debt ceiling, can (and likely will) still happen—US lawmakers always find a way to kick the can. Eventually, whether it’s in the next couple days or maybe even weeks, they’ll kick it again. Incentives (ahem, 2014 midterms) are too powerful to ignore. Congress will get past this, and markets should keep marching higher on strong fundamentals—including the same gridlock folks fear today.