Europe’s banking problems are the elephant in the room

If ever there was an example of a robust political system, it is Italy. The country has had 65 different governments under its current constitution, which has been in force since 1948. The average government lasts little more than a year — and yet Italy enjoyed a postwar economic renaissance that almost matched Germany’s. Italy’s system of government was so robust and impervious to party political turmoil that the latest change of prime minister would pass without even a blip on world markets.

That cannot be said of Italy’s latest political imbroglio. Investors have staged a classic flight to safety with the 10-year Treasury yield now down 24 basis points in just seven trading days. The last time it staged a rally this great came in the week after the UK’s Brexit referendum two years ago — the last time the eurozone seemed under threat.

Meanwhile stocks have sold off globally, with the FTSE All-World index, which includes both developed and emerging markets, testing its 200-day moving average, regarded as an important measure of the long-term trend. The last time world stocks traded below this trend also came in the week after the Brexit referendum.

The belief that the Italian job will force policymakers to change course also shows up in the belief, shown in Federal Funds futures, that the chances are now one in four that the Federal Reserve will not raise target interest rates next month. A week ago, a rate rise was seen as a virtual certainty, and the Fed’s new leadership has taken care to say that US monetary policy is not driving outcomes around the rest of the world.

So how can we reconcile such a drastic international reaction to such a common event as an Italian political mess? At one level, this is plainly an overreaction, following a protracted period when investors seemed oddly unconcerned about obviously concerning conditions in Italy. The chance that Italy will leave the euro or the EU, an enormously disruptive event were it to happen, remains very low but has risen. Markets are famously bad at gauging their reaction to low-probability extreme events.

At another level it speaks to the central weakness of the international financial world, which is the European banking system (eurozone bank’s shares have hit a fresh low compared with US counterparts), and its relation with the incomplete institutions of the eurozone. The European Central Bank has been able to avert disaster so far, but this latest global market fright shows that investors remain acutely aware of the underlying vulnerability.

In the short term, the likelihood is that Europe and Italy will muddle through, and that a decent entry point for buying European assets is at hand. But that is only for the short term. For the longer term, Europe’s banking problems need to be dealt with — inevitably at the cost of significant pain — or at some point a moment of stress like this will at last tip over into a crisis that ends the euro.

john.authers@ft.com