Here's how it got to this, and why Europe is so scared.
In late 2011, Italy's controversial PM Berlusconi was basically forced out of office by rising Italian yields.
Berlusconi's departure and the entrance of ECB-favorite technocrat Mario Monti was welcomed by markets.
Italian borrowing costs quickly fell, helped in part by the ECB 3-year LTRO program, which eased funding for banks.
Mario Monti has helped get things under control on the sovereign debt front, but the economy still stinks, and people are angry that an unelected technocrat has done what it takes to deal with bondholders, but hasn't done anything to improve the real economy.
Today's horrible services PMI report in Italy is a good reminder of how bad things are.
Italy is holding an election on February 24-25, and the favorite is leftist Pier Luigi Bersani.
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He started the election with a big lead in the polls, but the gap against Berlusconi's conservative party has been narrowing.
Nomura
Why has Berlusconi's party been rallying?
Former Prime Minister Silvio Berlusconi has cut the lead of front-runner Pier Luigi Bersani to 5 percentage points in the countdown to Italian parliamentary elections Feb. 24-25. Berlusconi is tapping into public anger over a banking scandal at Banca Monte dei Paschi di Siena SpA and soaking up the popular adulation over the signing of striker Mario Balotelli to Berlusconi’s Milan soccer team.
Monte dei Paschi is a bank that's closely associated with Italy's left. People hate bailouts.
And yes, people like that Silvio Berlusconi signed footballer Mario Balotelli to his soccer team.
Berlusconi even had an amazing quote comparing Balotelli to Mario Monti: "Balotelli is the better Mario. He scored two goals, and made Germans cry. Monti scored a property tax, and made Italians cry." (Via Alberto Nardelli)
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The belief is that the leftist Bersani is still going to win the election, but what if he doesn't?
JPMorgan's Alex White muses that if Berlusconi wins, Italian borrowing costs could rise, the ECB would need to step in and backstop the country, and that that would create political problems and anger in Germany:
But, what if…..?
Like us, European policymakers have (so far) regarded a Berlusconi victory as a tail-risk event, but they are now increasingly focused on the need to prepare for such a potential outcome. Concentrating their minds is a possible worse-case scenario, the ‘bad’ trajectory which we lay out below. We also lay out a more likely trajectory of events as we think they might unfold if Berlusconi were to win.
A bad trajectory
The worst fear for regional policymakers is that a Berlusconi victory, if managed poorly, results in heavy market pressure on Italy - ultimately forcing it to seek an ESM-ECCL package as a precursor to activating the OMT. German MPs would then be forced to vote on a support package that opened the door to ECB intervention for Italy with all of their moral hazard questions remaining unanswered (and with a Berlusconi Government the recipient of any support). Voters in Germany would be left asking serious questions about the OMT (effectively being faced with the evidence of what the ECB commitment can mean) and punish the Chancellor accordingly. Add in the (currently rather remote) fear of Draghi being further damaged by the MPS scandal and there is a risk of a very damaging hit to sentiment and to the prospects of Chancellor Merkel’s reelection. We think this is unlikely to happen; but it is the scenario that policymakers are focused on avoiding.
We thought the February 24-25 election was going to be boring. Now we're excited.