The Achilles heel of the euro has always been democracy. Although the euro is unlikely to break up, that risk cannot be entirely excluded: one day, voters may choose a government committed to policies that are incompatible with the conditions set by Europe’s leaders for membership of the single currency.

Democracy in the eurozone suffers from a structural problem and a policy problem. The structural problem is that the new rules agreed since the euro crisis began – including the ‘six pack’, the ‘two pack’ and the fiscal compact – have deprived national parliaments of the freedom to set the budgets which they believe are best for their country. The European Commission and other eurozone governments can now order a national government to revise its budget.

The policy problem is that the particular prescriptions pushed by eurozone governments, the Commission and the European Central Bank (ECB) – all dominated by German thinking – have exacerbated the debt problems of southern Europe, including in Italy. So long as the southern European economies shrink or fail to grow, subjecting many people to considerable pain, the EU and its leaders are going to be unpopular in those countries.

There is no silver bullet that can instantly revive growth in the eurozone’s periphery, but the EU’s current emphasis on austerity is condemning these countries to further stagnation. And so long as that endures, the risk of populist revolts against EU-driven policies will be permanent.

The strong showing for Beppe Grillo’s Five Star Movement in the Italian election shows that voters wanted to kick Italy’s corrupt and incompetent political class. But the fact that Grillo and Silvio Berlusconi between them won 56 per cent of the votes also signals a rejection of the austerity policies that Prime Minister Mario Monti and eurozone leaders prescribed for Italy. Both Grillo and Berlusconi made a point of criticising excessive austerity during the campaign.

Monti, who restored some sobriety to the governance of Italy and pushed through long-needed reforms, such as those to labour markets, is an admirable figure. Neither the ethically-challenged Berlusconi nor the flippant Grillo are inspiring leaders. Peer Steinbrück, the German Social Democrats’ chancellor candidate, may have been offensive when he said that the Italians had voted for two clowns, but he was not inaccurate. Nevertheless, Grillo, Berlusconi and those who voted for them had a point.

Italian borrowing costs came down following Monti’s election, as investors hoped that this would open the way for concessions from the German government. However, once it became clear that it would not, and that austerity was pushing the Italian economy deeper into slump, borrowing costs rose back to record (or very close to) record levels.

Of course, Italy’s problem of low growth preceded the formation of the Monti government: it has grown more slowly than all the other members of the euro since 1999. But fiscal austerity, which increased when Monti came into office, proved self-defeating. The economy shrunk by 0.8 per cent in the final three months of 2012, the sixth consecutive quarterly decline. It slumped by 2.2 per cent in 2012 as a whole and is now around 8 per cent smaller than it was prior to the onset of the financial crisis.  Despite running only modest deficits, Italy’s debt burden has been rising: the ratio of public debt to GDP moved from 103 per cent in 2007 to an estimated 128 per cent at the end of 2012.

Sadly, voters now associate structural reforms with slump, rising unemployment and social stress. The Berlin-Brussels-Frankfurt consensus on austerity implemented by the Monti government – and to some degree, the preceding Berlusconi government –  has discredited the very reforms that are needed to boost the performance of the Italian economy.

Of course, austerity alone is not responsible for the weakness of Italy’s economy; the lack of structural reform since the start of the euro in 1999 has contributed to a very weak record on productivity and thus growth. But as the IMF observed last November, the tightening of fiscal policy by eurozone governments (including Italy’s) has been excessive given the weakness of private sector demand. The tightening depressed an already fragile Italian economy and made it harder to consolidate the public finances. This is what Keynes meant by the paradox of thrift: if everyone spends less and saves more, everyone will become poorer (across much of Europe, citizens and especially companies are taking demand out of the economy by sitting on cash rather than spending it).

The implications of Italy’s elections for the eurozone will depend to a large extent on how the Commission, the ECB and the German government respond. They could react by acknowledging that their strategy for combating the eurozone crisis needs recalibrating. They could agree that the pace of fiscal consolidation in the eurozone periphery and France should be slowed, that Germany should embark on a fiscal stimulus and that the way should be opened for the ECB to cut interest rates and launch quantitative easing. Such shifts could help to prevent the further radicalisation of Italian politics and enable an Italian government – perhaps following another election – to sell structural reforms to the Italian electorate. 

However, if the Commission, the ECB and the German government respond to the election by saying, to quote Margaret Thatcher, “there is no alternative”, they will be laying the foundations for future and increasingly serious crises. Such an inflexible response would almost certainly undermine Italy’s already weakened mainstream and pro-EU political forces. And that, in turn, would almost certainly preclude the construction of an Italian government that was willing and able to push through structural reforms and fiscal consolidation. Politicians and voters in other southern European countries would take note.

Eurozone policy-makers had become strikingly complacent about the eurozone in recent months, with some going so far as to claim that the crisis was over. Although the spread between southern European government bonds and German bunds had fallen, helping to create an atmosphere of confidence, that did not reflect a revival of the problematic countries’ economies or the readiness of governments to address the eurozone’s weaknesses. Indeed, the economic situation in the peripheral economies has worsened rapidly since last summer, as have their debt burdens. Eurozone governments have agreed to place responsibility for supervising the region’s biggest banks in the hands of the ECB, but they are no closer to agreeing to mutualise risk by establishing a joint eurozone back-stop for their banks or by launching eurobonds.  

Borrowing costs fell steeply in the autumn of 2012 after the ECB announced it was ready to buy potentially unlimited amounts of peripheral country government debt (through ‘Outright Monetary Transactions’, or OMTs). This went a long way to dispelling the break-up risk that had caused borrowing costs across the periphery to balloon. But the OMTs always involved an element of bluff: for the ECB to commence bond-buying, the country in question would have to request a rescue from the European Stability Mechanism (ESM), the eurozone’s bail-out fund. That would involve the supplicant signing up to a programme of fiscal austerity and structural reform, which would have to be approved by all 17 eurozone governments, and in Germany’s case, its Parliament.

So the OMTs cannot work for a country whose government rejects austerity and supply-side reform. Grillo would probably oppose ESM conditionality, but is unlikely to form a government. Whatever Italian government does emerge, it is likely to be moderate, weak and incapable of delivering much in the way of spending cuts or reforms that tackle vested interests. Investors could start to doubt the credibility of the pledge by ECB president Mario Draghi to “do whatever it takes to save the euro”. Italy’s borrowing costs would soar as investors started to factor in the risk of the country leaving the euro.

The politics of the eurozone crisis are now formidably difficult, not least because the stand-off between Italy and the eurozone will be played out against the backdrop of Germany’s general election campaign. This will make it very hard for the Germans to alter their stance. Merkel has a huge interest in maintaining the pretence that the current strategy is working. And in Germany, the Italian result is seen more as evidence that Italians are unwilling to face up to their problems than as an understandable reaction to an intellectually bankrupt strategy.  The fact that the beneficiaries of the anti-austerity vote in Italy are unappealing populists such as Berlusconi and Grillo has reinforced the Germans’ view.

If Italy can find a serious government to negotiate with its eurozone partners, it does have cards to play. It is in a stronger position than the other peripheral eurozone economies. First, the Italian government runs a primary budget surplus (that is, a surplus before the payment of interest on outstanding debt). This makes it much less dependent than the others on support from the rest of the eurozone: if Italy were to default, the Italian government could still pay its bills. Second, Italy’s banking sector is essentially sound; the country does not face the need to raise large sums of money to recapitalise its banks. Third, despite having such a high level of public sector debt, Italy’s overall debt burden (that is, its stock of both public and private debt) is not only lower than the other peripheral economies, but also below that of France and the Netherlands. Fourth, Italy’s external asset position (Italians’ foreign assets minus foreigners’ investments in Italy) is broadly balanced; by contrast, Spain, Portugal and Greece owe large amounts of money to the rest of the world.

In summary, Italy is not quite the basket-case it is often portrayed as abroad. It cannot be so easily bullied as the other peripheral countries. Leaving the eurozone would pose fewer risks to Italy than to the others. This puts the Italian government in a stronger position to play hard-ball in negotiating its fiscal policy. 

In the short term, Italy’s voters have made it harder for Europe’s leaders to manage the euro crisis. But the Italians may have done Europe a service by shaking those leaders out of their complacency. Since François Hollande became France’s president, he has sought to soften the eurozone’s emphasis on austerity. His officials hope that, after the German elections in September, a coalition government including Social Democrats may be more willing to shift Germany’s stance. It is true that the Social Democrats are a little less austerity-focused than Merkel. French officials believe that countries with big current account surpluses such as Germany can and should do more to stimulate demand in the eurozone. But France needs to improve its own economic performance before it can gain much leverage over German policy. And if Italy, too, can somehow conjure up a stable and respected government – one that is serious about reform, but softer on austerity – it might help persuade Germany to rethink its policies.

Charles Grant is director and Simon Tilford is chief economist of the Centre for European Reform.