While the domestic airwaves are filled with “Breaking News” from Washington every five minutes about the U.S. government shutdown, fireworks have been going off across the pond in Europe.  Just uttering the words “Silvio Berlusconi” has become synonymous with “Italian Political Drama,” and yes, Mr. Berlusconi was at the heart of the latest flare up.

Late last week, Mr. Berlusconi announced his PDL party would not support the government of current Prime Minister Enrico Letta.   Italy had an inconclusive election earlier this year and the PDL party was part of a grand coalition across the political spectrum, so pulling out of the coalition government risked a collapse of Mr. Letta’s government at a time when key legislation to further reign in and restructure Italian fiscal policy is being implemented.  The week opened with political analysts almost certain that a political crisis was going to engulf Italy.

PDL means “People of Freedom” in Italian, and apparently its members took that to heart this week in a way that surprised Mr. Berlusconi.   A significant number of dissenters within the PDL came out earlier this week in support of Mr. Letta.  On Wednesday a vote of confidence was held and the Letta government survived.  The post-game analysis is that the Letta government, although still fragile, came out stronger by week’s end and Mr. Berlusconi suffered an embarrassing defeat.

But what I found fascinating was the reaction to all this in the markets.  Italian government bond yields rose about two basis points to nearly 4.43% when this drama first broke.  As the week unfolded, yields dropped slightly to 4.39%.  There was a slightly more pronounced dip and recovery in equities, but it still qualified as a relatively dull roller coaster ride.

Looking at how markets reacted to the drama back in the U.S., 10-year bond yields started the week at 2.61% and stayed within relatively tight ranges all week.  Even the drop in equities has been relatively moderate. 

My View:  Markets expect this to all work out well and seem to have gotten complacent on the potential for serious fallout from political malfunction.  Ironically, this is not a good development.  We have seen in past years that a sure way to get politicians to act is to have a good old-fashioned sharp market reaction.  Until that happens, we may not see the kind of movement we need to have to limit the damage of gridlock.

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