Berlusconi Out, German Government In

The curtain closed on Italy’s biggest political sideshow Wednesday, when scandal-plagued former Prime Minister Silvio Berlusconi got the boot from Parliament. Meanwhile, 1,500km to the north, German Chancellor Angela Merkel finally formed a government. On its own, neither event is terribly earthshattering. But together they illustrate the relative political calm that’s settling over parts of Europe—something markets should like.

Berlusconi’s expulsion came after a series of legal and political battles chipped away his Teflon coating. In August, he was convicted for tax fraud and received a four-year prison sentence. That was later commuted to one year of community service, but he was still subject to a law passed last year that bans convicted felons from serving in Parliament. Three weeks after his conviction, he threatened to pull his People of Freedom (PdL) party from PM Enrico Letta’s governing coalition if they voted to ratify his expulsion—but when key PdL members indicated they’d break with him and follow Letta, he backed down. Then, on November 16, PdL split for real. Berlusconi loyalists re-launched his old Forza Italia party, and 30 breakaway senators formed the creatively named New Centre-Right party, which remained in Letta’s government. This created much-needed stability for Letta’s cabinet and sealed Berlusconi’s fate. When the Senate voted, the result surprised no one.

Together, PdL’s split and Berlusconi’s absence should make it easier for Letta to govern. Before the split, Berlusconi was effectively kingmaker. No legislation could pass without his support, and he opposed many of the coalition’s proposed austerity measures and economic reforms. As long as he was in the cabinet, labor market reforms and other beneficial changes stood little chance of passing. Now that he’s out, sweeping change still remains unlikely, but more incremental measures should have a shot. Much-needed electoral reforms likely also have a somewhat clearer path. As does Italy’s political situation in general—without Berlusconi’s looming threat to break up the government, Letta’s cabinet should stay intact until new elections are called in 2015, which helps abate some of the eurozone’s lingering political uncertainty.

Germany’s political picture also became clearer with Merkel’s announcement, which came two months after the general election. Her Christian Democratic Union (CDU) and its sister party, the Christian Social Union (CSU), signed a coalition agreement with the center-left Social Democrats (SPD) outlining policies they’ll pursue over the next four years. Next up, SPD will send the deal to its 470,000 party members, who will vote to approve it by mail. Results will be announced December 14, though most expect it to be a formality considering SPD won concessions on some key campaign promises.

The agreement itself was largely in line with expectations. Foreign policy won’t change much—status quo in the eurozone—while domestic policy shifts a bit. Taxes won’t rise (fulfilling a key CDU campaign promise), but spending is expected to rise by 0.8% of GDP (an SPD pledge). All parties believe strong economic activity will generate enough new tax revenue at current rates to fund the higher outlays. But if growth falters, taxes could rise down the line due to new laws limiting the government’s ability to issue new debt to fund a spending gap. In the near term, however, that doesn’t appear to be a likely outcome.

Other proposed changes are incremental and may create a few winners and losers but shouldn’t alter Germany’s economic competitiveness. The retirement age will drop from 67 to 63 for employees with 45 years of service, infrastructure investment will increase, the Autobahns will become toll roads (offset for domestic drivers by a reduction in auto taxes) and a national minimum wage of €8.50/hour will take effect in 2015. They also substantially reduced renewable energy subsidies, which had the unpleasant side effect of making energy bills more expensive. The moratorium on shale fracking, however, will remain in effect for now.

Overall, aside from these changes, it’s difficult to envision Germany’s government passing legislation of much significance. With the coalition split between center-left and center-right, it looks an awful lot like the split US Congress—four years of gridlock seem pretty likely. Unlike in Italy, where gridlock was a headwind, in Germany it’s a positive. Germany already has one of Europe’s most competitive economies and doesn’t need a ton of reform the way certain peripheral countries do. In competitive countries like Germany, a higher likelihood of more sweeping legislation would raise the probability of changes to things like property rights, which markets don’t much like. Legislative calm there is a positive.

Overall, eurozone politics appear to be settling down. Greece’s budget process is on track, Portugal just passed its 2014 spending package, Spain is moving forward and now Italy is, too. It isn’t all smooth sailing, of course—anti-austerity protests continue, and Portugal’s Constitutional Court continues shooting down certain labor reforms and public sector cuts—but the region was never going to improve over night. Over time, however, incremental progress combined with continued German calm should help pull the region through—and considering how low expectations are, slow progress is likely all markets need to see.