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Italy’s problems are bigger than Berlusconi

Silvio Berlusconi

By Cyrus Sanati, contributor

FORTUNE — The potential resignation of Italian Prime Minister Silvio Berlusconi is no panacea for the deep-rooted economic troubles within Italy and the rest of Europe. While the markets responded somewhat positively to reports that Italy’s longest ruling leader since Mussolini is on his way out the door, there were still too few private investors willing to snap up Italian debt, sending Italian bond yields to their highest level since the founding of the euro.

The political mess in Italy, like the one currently in Greece, is not a surprise for traders familiar with the southern European markets. Italy’s fate is being decided not just in Rome, but also in Brussels, where euro zone technocrats are trying to concoct an elixir for the region’s sovereign debt crisis. Unfortunately, the political dysfunction that has gripped Rome has also paralyzed the EU. Both need to get serious about solving their respective political problems before the market writes both of them off for good.

Berlusconi failed to receive a total majority today in a normal budgetary vote, which had become a de facto vote of no confidence on his leadership of the Italian state. The main opposition party abstained from voting in an attempt to reveal the cracks in Berlusconi’s disparate political coalition. The vote ended up eight shy of the 316 needed to show that he had a majority in the Italian parliament. While the budget bill passed, as there were no votes against the measure, the failure to receive a total majority has put Berlusconi’s political future in doubt.

(Update: Berlusconi pledged to resign from office)

Italian theatrics aside, the vote today and its outcome are really just one of the many sideshows in the long-running European sovereign debt crisis. While an ensuing power vacuum and a technocrat-run interim government certainly isn’t the best choice for Italy at such a critical juncture in the nation’s economic history, it probably won’t spell disaster either.

Nor will the ousting of Berlusconi be the answer to Italy’s troubles. While it seems that the colorful billionaire is at times more interested in promoting his forthcoming album of Italian love songs than solving his nation’s fiscal woes, Italy’s problems predate his rule. Tough austerity measures will still need to pass if the country is to receive further assistance from the EU bailout fund and the European Central Bank. Berlusconi has already passed some tough measures that have put the country on the right course, but it still falls short of steering the errant battleship back to port.

3 biggest holes in Europe’s debt deal

The real trouble with Italy isn’t its leadership – after all, the country has functioned as a going concern despite having more than 60 different governments in the post-war era. Italians are used to constant turnover in their leadership and somehow the country has remained an economic engine for Europe. Its “old world” economy has managed to elevate its citizenry into a lifestyle that no one could have imagined just a few generations ago when millions of desperately poor Italian immigrants left the country in search of a better life in places like the United States and Argentina.

A big reason Italy has been able to live “La Dolce Vita” for as long as it has over the years has been its ability to sell debt – lots of it. Italy is home to the fourth-largest debt market in the world with $1.8 trillion euros outstanding. The nation’s shrinking economic power has meant that it has had to borrow more and more money to keep its sweet life going. Italy’s debt compared to its GDP currently stands at an alarming 120%, the second-highest in Europe after Greece at 140%.

This high debt to GDP ratio was never really a problem until recently. Like a profligate spending consumer with several low-interest credit cards, Italy just kept requesting larger and larger credit line increases when it needed quick cash. But when the era of easy money ended with the credit crunch, things started to get pretty hairy. Italy was a highly-rated sovereign so it was still able to attract capital to its liquid debt markets; it just had to offer investors a higher yield.

This is the root of Italy’s current problems. Since June, large pension funds and buy-side shops have shunned Italian debt, forcing Italy to offer even higher interest on its debt. This was a problem for an economic model that was predicated on the belief the country could borrow and roll over its debt at low interest rates ad infinitum. If it had to pay high interest, it would eventually go broke.

Central bankers to the rescue

Lucky for Italy, the European Central Bank, which is backed by all members of the euro zone, came riding to the rescue. When investors stopped buying Italian debt this summer, the ECB stepped in and bought Italian bonds on the secondary markets. This unprecedented, and legally questionable, intervention by the ECB helped bring in Italian bond yields to more manageable levels. The ECB said the intervention was an “emergency measure” and that it would be suspended once the recently enlarged European bailout fund, The European Financial Stability Facility (EFSF), was up and running.

After several months of political haggling, the newly enlarged EFSF was finally agreed to by all the members of the euro zone in October.  Soon after, the ECB reiterated that it would not be backing the fund and that it would be transferring bond buying duties to the EFSF in short order.

The market did not like that at all. Italian bond yields have steadily increased since the ECB made that announcement and have continued to do so even after euro zone nations agreed to lever up the fund by two to three times its newly enlarged size of 440 billion euros.

Meanwhile, the ECB has still been quietly buying up Italian debt. Last week it bought around 9.5 billion euros worth of Italian debt, double what it purchased during the previous week. Without the continued ECB intervention, Italian bond yields would have probably blown out into the double digits, European debt traders tell Fortune. There is still very little private demand for Italian paper given all the uncertainty in the market. The threat of an ECB pullout combined with talk of a government change helped push Italian bond yields to a record high 6.74% this morning.

This unsustainably high yield for Italian debt is the market’s way of telling Rome and Brussels: We still don’t believe you. It doesn’t believe that the Italian government, whether it is led by Berlusconi or technocrats, will make the tough changes necessary, to not only get Italy’s fiscal house in order, but to also help grow its way to prosperity. It doesn’t believe that the EFSF has the power to prop up Italy’s fledgling debt market -along with that of Greece, Portugal, Ireland and Spain – all on its own. And it doesn’t believe that the new plan to “lever up” the fund through clever financial engineering will work, either.

The Italians have around 300 billion euros worth of debt that it needs to roll over next year. The EFSF simply doesn’t have the ability to absorb that much debt and support the rest of the euro zone periphery. The EU and Italy need the private market to trust it once again. For that to happen, investors will need to be offered more than financial trickery and cheesy Italian love songs.