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.
