Weakest link in the eurozone

THE impasse in Rome is bad news for Italy and Europe's economic prospects.

"No Monti" day protests

THE trouble with Italy is that it is too big to save. A viable refinancing package for the eurozone's third largest economy, and the eighth largest economy in the world, would strain even Germany's resources beyond the breaking point. But it is far too early to say that Italy will collapse.

Rather, its fate may be even worse: to remain trapped in political instability and economic decline, serious enough to stall reform in the eurozone but not sufficient to bring the euro crisis to a head. Italy's turmoil would then entrench Europe's stagnation and aggravate the pressures pushing European voters to increasingly extreme options.

That Italy can survive a lengthy period of dysfunctional government is beyond doubt. Chaos at the top is as Italian as Sophia Loren. Italians' expectations of government are low, and rightly so: on the World Bank's index of government effectiveness, taking Switzerland as 1, Italy scores 0.1, placing it significantly below even Greece, Portugal and Spain.

In practice, political paralysis will change little in the daily life of Italians: for better or worse, Italy's government will continue to collect taxes and pay its bills. And it will continue to service its debt, all the more so as the Italian treasury made good use of the past year's lull in sovereign risk premiums to reduce its immediate refinancing requirements.

Hopeless but not desperate, like the Austro-Hungarian Empire in its twilight, Italy can therefore stagger on. But there is one thing a paralysed political system cannot do: address the root causes of Italy's problems.

Since 1992, real gross domestic product per capita has increased by about 0.4 per cent a year, a growth rate lower than Japan's. At that rate, it takes 150 years for incomes to double: the only way people can improve their lot is at each other's expense, rather than by sharing in the fruits of expansion. Knowing that, and fearful of being at the losing end of any redistribution, each defends their own, making policy reform a zero-sum game and entrenching the distortions that prevent growth.

Those distortions are as pervasive as they are longstanding. In their present form they date back to the late 1960s, when Italian governments faced a wave of industrial unrest that not only crippled Italy's economy but had insurrectionary overtones. Buckling under the threat, governments allowed nominal wage growth to explode, with wages rising at an annual average rate of 20 per cent during the 70s, more than five times the growth rate of productivity. Superimposed on the recessionary effects of the oil shocks, the result was to destroy the viability of Italy's largest employers and its exporters, making mass lay-offs seem inevitable.

As those lay-offs loomed, the political response was fourfold. Employment protection laws were enacted that made retrenchments virtually impossible; so as to allow employers to nonetheless survive, government subsidies to industry increased dramatically, peaking at about 15 per cent of the corporate sector's value added; to buy social peace, other public spending was also boosted, with government expenditure growing from about 30 per cent of GDP in the 60s to more than 50 per cent by 1980; and as tax revenues increased by much less than that, the budget deficit, which had been below 1 per cent of GDP in the early 60s, blew out to more than 10 per cent of GDP by the late 80s.

That all this was unsustainable was obvious. Yet its devastating costs were initially masked by a series of devaluations that helped restore the competitiveness of Italian manufacturing. True, the devaluations stoked inflationary pressures, as prices of imported energy and raw materials rose and as unions clawed back falls in real wages; but at least in the short run the resulting inflation also reduced the real cost of social transfers and eroded the value of outstanding public debt, bringing some relief to the public finances.

Italy's economic performance therefore remained surprisingly good, with real GDP growth rates in the order of 3 per cent annually. By 1984, social tensions had abated and a new government, led by the Socialist Party's Bettino Craxi, could count on a relatively stable majority. But Craxi wasted the opportunity for reform. Instead, focused on amassing a personal fortune estimated at more than $1 billion, he took corruption to new heights, including in helping Silvio Berlusconi establish and protect his media empire.

Despite that, these too seemed good years for Italy's economy. They were symbolised by Craxi's triumphant announcement in 1987 of il sorpasso (the overtaking): Italy's GDP, for the first time since the 15th century, had exceeded that of Britain. But this was fool's gold. With the government's finances still out of control, the ratio of public debt to GDP leapt during the 80s from 56 per cent to 94 per cent and it became clear to Italy's business leaders that there was little prospect, if any, of home-grown reform.

Attention therefore shifted to the need for an external constraint that could limit inflationary expectations, discipline public spending and force greater flexibility in labour market regulation.

Dramatic events soon brought that search for an external constraint into even sharper focus. In 1992, the government's unwillingness to quell inflationary pressures forced Italy to unceremoniously abandon the fixed exchange rate bands of the European Monetary System; and in the same year, mani pulite (clean hands), a vast corruption inquiry launched by the Milanese magistracy, got under way, ending Craxi's career (he fled to Tunisia, where he died in 2000) while destroying virtually all of Italy's political parties.

As the train wreck unfolded, a consensus emerged in what remained of Italy's elite: that, in the words of Guido Carli, long-time governor of the Bank of Italy, only "importing European virtues" could "overcome Italian vices".

From that consensus was born Italy's determination to join the euro: not as a way of strengthening Europe but of saving Italy. As Mario Monti, who would eventually become the "technical" prime minister charged with implementing that strategy, eloquently put it, "Italy needs the euro because she cannot have Mrs Thatcher." The straitjacket of the euro would push a reluctant Italy, which could not sustain a viable internal constituency for change, on to the path of reform.

It is that strategy that has now spectacularly failed. But its ineffectiveness was obvious almost from the start. The transition to the euro, which became the eurozone's legal tender on January 1, 2002, did see some reform efforts, including far-reaching privatisations; but those efforts were poorly implemented and in many cases counterproductive (the changes to public administration, for example, ultimately increasing the extent of patronage).

In the absence of domestic political support for wide-ranging reform, the Berlusconi governments more often than not went backwards, especially as Berlusconi's attention was on preserving his media empire. The centre-left governments that punctuated Berlusconi's period in office did seek to increase the sustainability of the pension system and slightly ease labour market regulations; but they lacked the stomach and the backing for comprehensive change.

To make matters worse, the coming into effect of the euro actually reduced the impetus for reform. The euro's immediate impact was to substantially reduce official interest rates, thus lowering the cost of servicing Italian public debt; governments therefore felt less need to control other public spending, which increased as a share of GDP. And with the labour market largely unreformed, wages resumed their rapid increase; but productivity growth was barely above zero, so that unit labour costs rose by nearly 3 per cent a year more than those in Germany, hammering Italy's competitiveness.

Italy was therefore extremely poorly placed when the crisis hit in 2008. And those difficulties were aggravated by a steady decay in public trust. Corruption, which had never been entirely eliminated, had returned with a vengeance, with scandals hitting all the political parties, from the right-wing Northern League to the refounded communists. Moreover, the inquiries into those scandals highlighted the extraordinarily generous terms on which taxpayers financed the main parties, with press reports estimating a cumulative cost, over a 20-year period, of 2bn euros, most of which had simply disappeared.

The unsurprising result was that when the time for austerity came, Italians had little reason to believe belt-tightening would be implemented in a way that shared the burden fairly, much less that today's pain would be offset by tomorrow's gain. Yet Monti's government could not effectively address those concerns.

Instead, it focused on increasing taxes, which had already risen steeply in the first part of the 2000s, and on raising tax collections; some of those increases proved badly targeted, hitting retirees with relatively low incomes, while the packages themselves were opaque and difficult to understand.

Moreover, rather than motivate reform by the gains to Italy's long-term prospects, the Monti government too often presented tough measures as the price Italy had to pay to appease German pressures - a price Monti himself argued was unduly high. With GDP shrinking during the past four years by more than it had in the Depression of the 30s and youth unemployment hitting 35 per cent, the reform package was therefore an easy target for the campaign unleashed against it by all sides of Italian politics. That package is now dead. But what will follow it is entirely unclear.

In formal terms, the Left will have a majority in the lower house. But Italy's bicameralism gives equal powers to the Senate; the great winners there have been Berlusconi, who has no reform program worth speaking of, and comedian Beppe Grillo's Five Star Movement, which won 25 per cent of the vote.

Grillo's supporters, known as the Grillini, are an extraordinarily varied group; and while Grillo has an election manifesto significantly influenced by economist Joseph Stiglitz (who was also an influence on Kevin Rudd), advocating a substantial stimulus package, the party's elected representatives are unlikely to act cohesively. They are nonetheless committed to holding a referendum on the euro, which seems likely to be accepted by whichever coalition forms government.

The outcome of that referendum is impossible to predict. After all, Italians have even less confidence in their own institutions than in Europe's; they may therefore prefer to remain in the eurozone, despite their anger over the austerity measures. But the events leading to the referendum will act as a flashpoint for Europe as a whole, highlighting the enduring weakness of the euro project.

That weakness lies in its conception as a policy unsupported by a politics, but that nonetheless seeks to impose costly limits on national political systems. In democracies, constraints must be chosen; and new policies, if they are to succeed in reshaping society, must be based on a new politics that aggregates coalitions capable of bearing the costs and sharing the benefits. In Italy, there is no longer any such coalition that can support the euro; in the other countries of the eurozone, those coalitions are increasingly brittle.

The Italian labyrinth will not be the death of those coalitions; they can muddle on for a while longer. But the success of their Italian counterparts will galvanise the euro's opponents elsewhere. And continuing turmoil in Italy will impede, if not entirely prevent, any progress by the eurozone in shaping viable institutions. With Europe already facing the prospect of years of stagnation, and its social capacity for growth steadily shrinking, it may well have been better had Italy actually failed.