Friday, January 20, 2012

Italy in crisis. Again.

Not much action on these pages in the last few days, largely because I've been writing a piece on Monti and the Italian crisis. And you lucky readers get to see the draft first. Here goes:

Italy has long been seen as a weak link in the Euro. Back in the 1980s, when plans for monetary union first began to take shape, fears that Italy’s political instability and fiscal indiscipline might derail the project were a serious obstacle to progress. The stringent criteria laid down by the Maastricht Treaty for participation in the Euro were designed with Italy and its large public debt in mind, and the Growth and Stability Pact which unsuccessfully governed the Eurozone’s public finances through the 2000s was principally aimed at curbing deficit spending south of the Alps. The current scenario, in which Italy’s creditworthiness is doubted by the financial markets and its debt problems are beginning to seem unsustainable, is the nightmare European policymakers have long dreaded. With Italy in trouble, the once apocalyptic danger of a Greek default is now seen as no more than a little local difficulty. 

The financial crisis has had a dramatic effect on Italian politics. It provoked the resignation of Silvio Berlusconi as Prime Minister, sidelining the dominant figure in Italian politics over the past two decades. Berlusconi had survived two election defeats, several trials for corruption and a sex scandal involving under-age prostitutes, but could not survive the Italian government bond yields hitting 7%. Equally dramatically, the same Italian parliament that had kept Berlusconi in office quickly lent its overwhelming support to a non-elected, non-partisan technocrat, Mario Monti, a former European commissioner. Of course, Monti is hardly an ‘apolitical’ figure, but his elevation to the Prime Minister’s office constitutes a stark recognition by Italy’s elected politicians of their inability to address the crisis effectively.

Monti’s first moves in office revolved around an emergency budget of tax rises and spending cuts designed to reduce the government deficit by €24 billion, and send a signal to the markets that Italy was determined to honour its debts. In the short term, these measures had little if any effect on market confidence: the spread between Italian and German 10 year debt, after dipping before 4% after Monti’s appointment, quickly climbed back to over 5%, a level generally considered to be unsustainable. So can the Monti government do anything to resolve this crisis? The rest of this article assesses the reasons for Italy’s economic decline, and the prospects for reform of its political and economic institutions. It argues that there is no quick fix for Italy’s problems, which are embedded in the structure of its political economy, and that there is no coherent political coalition in favour of reform. As in the past, the most likely route to change is a further delegation of power to the European Union.

The Italian Economy in Crisis

Although Italy has been lumped together with Greece, Spain, Portugal and Ireland in a group of troubled economies known in sarcastic shorthand as the ‘PIIGS’, its economic problems are in fact rather distinctive. Whilst Greece, Ireland and Spain all enjoyed economic booms over the past two decades, Italy’s growth rate since 1990 has been the lowest of any advanced economy, including deflation-prone Japan. Whilst the other struggling economies in the Eurozone periphery have run up most of their private and/or public indebtedness in the decade since the Euro’s inception, Italy’s huge national debt (around 120% of GDP, making it the third largest in the world) has been stable since the early 1990s. Unlike Greece, Ireland or Spain, Italy’s budget deficit has been amongst the lowest in Europe since the 2008 financial crisis. So why have the markets only now become so alarmed at Italy’s fiscal position?

On one level, Italy’s fiscal problems are simply a function of the size of its economy. Whilst the Greek government has borrowed a much higher share of its GDP than Italy, the Greek economy is very small (around 2% of the Eurozone economy), whilst Italy has the third largest GDP in the Euro area. Italy is ‘too big to bail’ using conventional instruments, and financial markets are not convinced that Europe’s leaders have the political will to ensure through other means that Italy will not default. With such a large debt to service, credibility problems very quickly become self-fulfilling. In these circumstances, any doubts about the Italians’ commitments to their creditors have rapidly become magnified.

Of course, there are plenty of reasons for investors to harbour such doubts. Italy’s other big problem is growth, or lack of it. If the Italian economy was barely expanding in the ‘good’ times of the 1990s and early 2000s, how can it be expected to grow amidst the worst global crisis since the 1930s? Worse, the Italian economy suffers from glaring structural deficiencies. It has an inefficient bureaucracy, an impenetrable legal and regulatory system, endemic corruption and tax evasion, and parts of the country in the hands of criminal gangs and locked in a cycle of stagnation and social decay. Italy’s system of worker representation and wage bargaining is less and less suited to meeting competitive pressures, whilst its welfare institutions fail to promote social mobility and inclusion, focusing instead on maintaining a large and growing retired population. In short, the growth prospects appear bleak, and if Italy cannot grow, it will not be able to service its debt at the high interest rates currently prevailing.

The European Union leadership insists that Italy can pull out of this crisis through austerity and reform. Borrowing needs to be reduced, and structural problems that are holding back the economy need to be tackled. This will involve government taking painful and unpopular decisions, decisions which populist leaders such as Silvio Berlusconi have proved stubbornly unwilling to countenance. Berlusconi’s replacement by Monti seeks to address this failure of political will. But the austerity and reform project faces formidable economic and political obstacles. The next two sections discuss these in turn.

Going for Growth? Retrenchment and Reform

Italy’s economic problems are well documented and ostensibly well understood. Although Italy’s political institutions are widely considered to be corrupt, opaque and ineffective, the Bank of Italy, the country’s central bank, is so well respected that its former head, Mario Draghi, was a shoe-in to succeed Jean-Claude Trichet at the helm of the European Central Bank. Italian universities produce well trained economists in abundance, and leading academic economists such as Alberto Alesina of Yale and Francesco Giavazzi of the University of Milan have been prominent advocates of reforms to make the Italian economy more competitive. The consensus view is that Italy’s excessive regulation and laborious legal procedures, alongside the government’s wasteful spending, holds the economy back. Businesses face too many pointless obstacles in going about their activities, and the tax burden is too high and too uncertain.

There is no shortage of supporting evidence for this view. In Italy, simple administrative procedures can take days, tax law is complex and inconsistently applied, and banal legal disputes can be bogged down in the courts for years. Labour law imposes significant rigidities in hiring and firing, and embeds wage bargaining at the sectoral level, increasing costs for many firms. Government spending in Italy is around 50% of GDP, way above the average in the OECD, yet education, research and development and basic social services are underfunded. The deadweight costs of state inefficiency are particularly severe in the South, as the interminable saga of Naples’ refuse collection crisis attests.

This diagnosis fits neatly with the policy advice coming from Brussels. The European Union’s ‘2020 agenda’ of economic reforms, inspired by measures adopted in Europe’s most successful economies, provides a blueprint of the kinds of changes that could resolve these problems: investment in skills and education, labour market changes to increase employment, and a focus on research and innovation. Similar advice is offered by other international organizations, such as the OECD and the IMF: Italy should shift its government spending to prioritize investment in human capital, cut waste, and liberalize markets. The Euro debt crisis has led to these calls being made with ever greater urgency.

Unfortunately, these measures are neither easy to implement, nor are they guaranteed to make a substantial difference to Italy’s growth rate. In fact, Italy has already adopted a wide range of important structural reforms over the past 20 years, including a sequence of labour reforms facilitating temporary contracts and part-time work, the privatization and consolidation of a large part of the banking system and the part-privatization of a number of industrial companies, reforms of the revenue system and the pensions system, and numerous initiatives to reduce bureaucratic complexity. In spite of these changes, growth has nonetheless ground to a halt over the same period. To say the least, this suggests that structural reforms are not a magic wand.

The dilemma facing Italian policymakers is heightened by the inauspicious global economic environment in which further reforms will have to be implemented. Much of the pressure for reform has focused on the labour market, and in particular the much debated Article 18 of the labour code, which restricts the circumstances in which workers in medium and large firms (over 15 workers) can be fired. But reforming Article 18 would inevitably exacerbate the deep pessimism of Italian households, who have already responded to the fear and uncertainty over the future by reducing their spending significantly, pulling the economy down with them. In a climate of retrenchment, restrictions on employment protection would compound the effects the crisis on consumer confidence, already at a 16-year low.

Similar points can be made about government spending. European policy-makers have pressed for pension reform as a way of reducing budgetary pressures, since pensions are a greater share of government spending in Italy than in most other European countries (around 15% of GDP). However reductions in pension entitlements again reduce consumer confidence and increase households’ propensity to save rather than spend their declining income. The problem is all the more severe because a relatively generous pensions system has acted indirectly as a broad social policy buffer in Italy, given the high degree of inter-family solidarity and the importance of pension income as a supplement to the resources of younger generations.

To be sure, there are a number of areas where reform and retrenchment are unambiguously necessary and desirable.  The wasteful and often corrupt use of public money in public infrastructure investment – such as for example the continuing financing of the unrealistic project for a bridge over the Straits of Messina, despite no actual construction work being planned – needs to be addressed. A serious attempt to address the labyrinthine nature of the legal and administrative systems would almost certainly produce extensive public sector productivity gains. The distortions in the tax system act as a disincentive to innovation and subsidize weaker sectors of the economy, as well as penalizing honesty. And a number of markets for services – the law, pharmacy, taxis and hauliers, for example – could be opened up to competitive pressures to improve efficiency. But if these reforms were so obviously favourable to growth, one has to wonder why they have not been implemented already. To understand why such apparently dysfunctional institutions have survived for so long, we need to examine the politics of Italy’s economic choices.

‘Eppur si muove’: From Growth to Stagnation

Thirty years ago, the economist Mancur Olson wrote an influential book, The Rise and Decline of Nations, which sought to explain why some democracies had enjoyed faster growth than others in the post-war period. Olson’s thesis was that long periods of peace and stability allowed vested interests to tighten their grip on policy-making, protecting their own positions at the expense of the economy as a whole. He argued that Italy, along with the other countries defeated in World War II, was growing faster than the UK and the US in the 1970s precisely because its elites had been replaced in the aftermath of its defeat.

Three decades later, Olson’s theory seems to fit the Italian case rather well. Since the 1980s, Italy’s economy has grown little, but the power and influence of vested interests seems stronger than ever.  And although the current pressure for reform for the most part targets unionized production workers, pensioners and other beneficiaries of public spending, these groups are not necessarily the key obstacles to economic dynamism. Indeed there is a strong case for arguing that Italy’s fiscal problems are in large part the result of a failure to confront the immense privileges enjoyed by the country’s small and medium-sized businesses and self-employed professionals and tradespeople. These privileges are in turn the consequence of a deliberate strategy followed over decades by the ruling parties in order to consolidate their electoral support.

The origins of this strategy can be found in the aftermath of the war, when Italy was deeply politically divided. Large areas of central Italy in particular were under the control of anti-Fascist partisans who had fought against the Nazi occupation alongside the Allies, and mostly sympathized with the Italian Communist Party (PCI). As the new battlelines of the Cold War emerged, the Allies threw their weight behind the Italian Christian Democratic party (DC) determined to avert the risk of a Communist takeover at the heart of the Mediterranean.  The DC was successful in winning the first democratic elections held in 1948, but the PCI was the dominant opposition party, and Communist support grew over the post-war period, peaking at 34% of the vote in the early 1980s. The effective American veto on Communist access to government power meant that the DC was ‘condemned to govern’, and the Christian Democrats used their decades-long presence at the heart of the state to lock in their dominant position.

Ironically, part of the Christian Democratic strategy involved adopting the same kind of statist economic policies usually associated with Communism, taking large areas of industrial production under direct or indirect government control. The DC and its governing partners also expanded state employment on a huge scale, rewarding their supporters with secure state jobs, pensions and other forms of state aid. As the left grew in strength, further spending commitments – particularly on pensions and welfare - were offered to buy industrial peace. By the 1970s the resulting pressures on government spending were outstripping the Italian economy’s ability to deliver growth in tax revenue, and the borrowing spree that led to today’s debt problems began in earnest. By 1992, Italy’s deficit had hit double figures and the government was plunged into financial disarray. The debt burden Italy faces now is essentially the unresolved inheritance of the chaotic public finances of the late 1970s and 1980s.

Of course, public borrowing is a function of both spending and revenue, and the fiscal crisis was also a consequence of an inadequate tax policy. As part of its electoral strategy the DC had encouraged the emergence of an extensive small business and self-employed sector of farmers, shop-keepers, artisans and tradespeople of various kinds. These groups were (and still are) often protected by strict regulations which prevented market entry for outsiders, the classic example being the tight control on the number of taxi licenses, providing taxi drivers with income security and the guarantees of future livelihoods for their children (these valuable licenses can be inherited or sold). Crucially, lax and often corrupt tax inspection regimes relieved these sectors of a large part of its fiscal burden. Small business owners and self-employed workers systematically under-reported their incomes, sometimes on a colossal scale; the recent raid on the luxury ski resort Cortina d’Ampezzo, in which tax officials checked the tax returns of the owners of luxury vehicles, revealed that many of them were declaring gross incomes of under €30,000 per year. At the same time, the tax and social security burden on employees of larger firms grew disproportionately, reducing the real value of salaries and hindering employment growth.

The postwar Italian economy, then, was built on a complex web of political exchanges which reached across the political spectrum and over-committed the state. What is perhaps surprising is how long it took for this system to run into the buffers, given the rewards for corruption and unproductive rent-seeking that it generated. One academic study of the Italian economy was entitled Il calabrone Italia, which we can loosely translate as ‘the Italian bumble-bee’, because it was not clear how the economy could keep moving under the weight of politicized government interference. But the financial crisis of the early 1990s, and the subsequent move toward European monetary integration, forced dramatic changes.

Saved by Europe, but for how long?: Berlusconi and the Euro

1992 was a momentous year for Europe, with the completion of the single market and the ratification of the Treaty of Maastricht, which committed member states to creating a single currency. But it was also a turning point in recent Italian history, as the Christian Democratic coalition, which had governed Italy in various forms since 1948, fell apart. A poor election result was followed by a spectacular wave of corruption scandals involving the DC and its coalition partners. Within weeks, most members of the Italian parliament were formally under investigation for corruption, and the governing parties effectively ceased to function. At the same time the Italian government was on the verge of debt default, whilst the Italian currency, the lira, was facing devaluation. A government with cross-party support under Giuliano Amato set about addressing the government finances whilst preparations were made for new elections, to be held under a new electoral system based on ‘first-past-the-post’ principles of voting used in most of the English-speaking world.

The ‘DC system’ had come to an end, and political commentators dramatically announced the end of the ‘First Republic’. The DC was formally dissolved at a congress in 1993, its leaders too concerned with their legal defences to think about getting re-elected. The second largest governing party, the Socialists, were if anything worse hit, with their powerful leader Bettino Craxi taking refuge from prosecutors in his holiday home in Tunisia, where he remained, free from extradition, until his death in 2000. With the collapse of the governing parties, the only organized political force remaining was the Communist party, which in 1991 had formally abandoned its Marxist doctrine and reformed as the Democratic Party of the Left (PDS). Into this vacuum stepped Silvio Berlusconi, media tycoon, owner of Italy’s third largest commercial TV channels, and close friend of Craxi.

Using his media power, money and a national network of advertising salesmen Berlusconi performed a miraculous feat: in just a few months he built a political movement, Forza Italia (Go, Italy!) that became Italy’s largest party in the 1994 elections, and elevated its leader to the Prime Minister’s office. Ostensibly supportive of the popular investigating judges who had unveiled the corrupt practices of the DC, Berlusconi was in fact fighting for his own survival. Not only was his business empire burdened with huge debts and his key poltiical ally, Craxi, on the run, but his own financial affairs had also begun to attract the attention of the Milanese magistrates. Getting elected was a high risk strategy to avoid the election of an unsympathetic left-wing government, and move beyond the reach of the courts. Thus began a political career that has dominated Italian politics for the past 17 years.

Berlusconi’s first experience of government ended abruptly with a formal notification of judicial investigation being handed to him as he hosted a G7 summit in Naples. Forza Italia went into opposition, and in what now appears as a rehearsal for the current governing arrangements, the technocrats took charge. Lamberto Dini, a former Bank of Italy executive, formed a caretaker government which passed a major pensions reform seen as a sine qua non of participation in EMU. After Dini, further elections were held, and a centre-left government was elected under Romano Prodi, with former Bank of Italy Governor Carlo Azeglio Ciampi as Treasury Minister. The Prodi government adopted a number of economic reforms and took stringent budgetary measures, including a so-called ‘Eurotax’, which reduced Italy’s borrowings enough to allow participation in the first wave of monetary union in 1999. The technocrats had turned the public finances around, set Italy’s debt burden on a downward path, and begun the process of dismantling the Christian Democrats’ political machine.

However, such rigour was not to voters’ tastes, and by 2001, Berlusconi had returned to power in an election landslide, promising ‘less taxes for everyone’. This time, Berlusconi governed for a full five year term, with a solid parliamentary majority. But this opportunity to push through unpopular reforms was missed: apart from a labour reform, the so-called ‘Biagi law’, which extended temporary contracts, few regulatory changes were made, and Berlusconi showed more interest in judicial reforms which would hinder the prosecutors investigating his business affairs. Despite the historically cheap borrowing costs resulting from Euro membership, the steady improvements in the public finances slowed to a halt. After losing the 2006 elections, Berlusconi won power again two years later, on the back of deficit-busting promises such as the abolition of the ICI, Italy’s local property tax, and a state rescue of the bankrupt national airline Alitalia. The deficit once again began to climb, as the bursting of the sub-prime bubble in the United States degenerated into a global crisis.

Berlusconi’s political demise can be seen as the inevitable consequence of Italy’s failure to adapt to the dramatic changes in the world economy since the early 1990s. The removal of the corrupt Christian Democratic elite and the adoption of profound economic reforms allowed Italy to take its place in the Eurozone, but once this challenge had been met Berlusconi skilfully persuaded Italian voters that the time for pain was over. Whilst promising a ‘new Italian miracle’ in the economy, in practice Berlusconi’s governments made few reforms, and failed to exploit the virtuous circle of falling deficits and interest rates to attack the government debt burden. At the critical European summit in November 2011 held to address the dramatic collapse in market confidence, Berlusconi insisted against all the evidence that Italy’s economy was so healthy that it was hard to book a restaurant table. His resignation suggests that Italy is no longer a country in denial. But can it address its problems and remain in the Euro?

What Is To Be Done? Rigour, Reform and the Populist Trap

Mario Monti’s arrival has been greeted as a breath of fresh air by other European governments, which had become increasingly frustrated at Berlusconi’s inability to deal with the crisis. An Italian public weary of scandal and economic decline has also extended a wary line of credit to the new technocratic administration. But the main difficulty Monti faces is that his reform programme will create  winners and losers, and only the latter are generally well organized. To invoke Olson once again, economic reforms will tend to impose concentrated and immediate costs on well defined producer interests, whilst the benefits will mostly be diffuse, and enjoyed by the broad mass of Italian consumers over a longer period of time. In other words, the costs are politically far more visible than the benefits, making reforms politically hard to sell.

Of course, the same argument could have made about the reforms Italy adopted in order to get into the Euro, and yet these obstacles were overcome, largely because Italians were fearful of the consequences of remaining outside. The so-called ‘vincolo esterno’ (external constraint) was a crucial component of this first wave of reforms, as Italians accepted a period of fiscal tightening and wage restraint to meet the requirements of the Maastricht Treaty. This time around, the threat is no longer of failing to meet the cut, but of being thrown out of the club. Will this prove a sufficient incentive to overcome vested interests opposed to reform?

Exit from the Euro would certainly be an extreme option, fraught with risk for the broad mass of Italian voters, many of whom hold financial assets which would be devalued as a result. This grim scenario will concentrate voter minds. However, remaining inside is no easy option, since the conditions for any bailout will surely involve both a long period of austerity, and the Italian government losing a large part of its fiscal sovereignty. Whilst the prospect of Euro entry in the 1990s could be presented in optimistic terms, continued Euro membership in 2012 simply evokes, at best, more of the same. Greece’s nightmarish descent into fiscal chaos and economic depression since its debt problems began is not a good precedent, and makes it harder to win political support for measures which may in the short term make things worse rather than better.

Monti’s appointment as Prime Minister represents a gamble that Italians will place their trust in a technocratic solution to their acute economic problems. Monti is certainly an impressive figure, with his background as an academic and subsequent a European commissioner, a man who speaks several languages is at ease in international summits. His political legitimacy therefore rests in part on his expertise, and in part on his lack of political baggage. Monti can claim to be about the partisan fray and free of debts to vested interests; in his administration reforms are presented as the rational, technical solution to practical problems. This means that the reforms must produce results if the technocratic route is going to enjoy the kind of political authority necessary to bring about sweeping changes in the Italian way of life.

The technocratic route also implies an explicit rejection of the normal rules of democratic politics. The failure of the existing democratic institutions to prevent the crisis has legitimized, like in the 1990s, a non-partisan route to reform. But the experience of the 1990s shows that electorates can only take so much of this kind of medicine. Once technocrats such as Dini and Prodi had secured Euro entry, Berlusconi’s populist rhetoric restored normal service. In the likely scenario that Monti’s reforms fail to quickly reverse economic stagnation, populist appeals from left and right will gain traction. Umberto Bossi’s Northern League, ostensibly committed to separating Italy’s prosperous north from the rest of the country, supported Berlusconi for a decade, but has refuse to back Monti and is preparing to exploit popular anger at the crisis. On the left, the fastest growing political force is led by a comedian, Beppe Grillo, whose tirades against the political class have been so popular that he has formed his own political party. Grillo has no real policies, but his message that Italians have been let down by their corrupt leaders has attracted a sizeable following.

Rejection of mainstream politicians has become a widespread sentiment, especially amongst the young, who are increasingly reluctant to join or vote for traditional political parties. With no end in sight to the economic downturn, and Europe’s leadership looking increasingly beleaguered, a message of continued austerity and reform will not go down well at the next parliamentary elections, due in 2013. Italy’s economic problems have fundamentally political causes. There is no coherent electoral coalition to support any of the measures considered necessary to resolve the crisis, and the weakness of Italy’s political parties makes it hard to imagine such a coalition being forged by the persuasive rhetoric of political leaders.

As a result, the most likely source of reform is, as in the 1990s, the delegation of policy decisions to the European institutions. The policy currently emerging appears to be a combination of monetary loosening in Frankfurt, combined with much stricter budgetary rules for the member states. By giving up the lira, Italy bound itself to a strict monetary policy, and now it may have to give up its fiscal autonomy in order to maintain Euro membership. Italians harbour few illusions about the integrity and effectiveness of their political leaders, and have been mostly quite sanguine about the loss of national sovereignty inherent in the European project. Italy may reluctantly accept being ‘saved by Europe’ once again. But if the crisis continues, the patience of the long-suffering Italian voter will come under severe strain. If Italy turns back to populism, there will be dramatic consequences for the governance of the European economy.