The turmoil in Italian politics continues and is likely to come to a head before the end of 2014. Six months after promising a catalogue of reforms, new Prime Minister Matteo Renzi has delivered little and the economy has got worse. Now he faces finding 20 billion euros to meet the commitments he has made to Brussels.

Professor Enrico Colombatto

ITALY’S flamboyant Prime Minister Matteo Renzi promised to introduce crucial reforms which would jump-start the economy and solve the country’s major problems. That was six months ago.

He assured Italians, when he took office in February 2014, that he would lower taxes without violating European budgetary rules, introduce labour-market liberalisation, greater efficiency of the judiciary, higher performance and eliminate waste in the public sector. His battle cry was ‘one reform a month’.

So far, Italians have not seen a single reform. Instead, tax pressure is rising with tax revenues in 2013 above 44 per cent of gross domestic product (GDP) and above 53 per cent if one excludes the underground economy. GDP-growth has been revised down to almost zero, the budget deficit is widening, and unemployment is fairly stable at 13 per cent.

The political situation is also confused. It is unclear whether Mr Renzi plans to reform the electoral law and call elections in early 2015 – despite his earlier promises to remain in office until 2018 – or whether he wants to concentrate on delivering at least some of his grand projects.

Special treatment

In the short term, the most worrying part of the picture is the deteriorating economy.
Mr Renzi told Italians on July 24, 2014, that it makes no difference whether GDP grows by 0.8 per cent or 0.2 per cent. He may believe this, but he will soon find out that GDP-growth makes a difference to the average Italian and their expectations for the future. More than that – it also affects the ratio between the public deficit and GDP. This means that if actual GDP growth is less than expected, and public spending is greater than expected, taxes will have to increase to bridge the gap.

For Italy, this gap is currently estimated at between 20 and 30 billion euros. Mr Renzi, of course, denies there will be further tax increases, but those denials may not mean much in the face of hard realities.

Italy will be facing hard times in a few weeks. Mr Renzi will probably try to persuade the European authorities to make an exception again and allow him to run a larger budget deficit. The European Union is likely to reject the proposal, as it has done before, arguing that there is no reason why Italy should receive special treatment.

Should this happen, the options will be limited. Mr Renzi can ask parliament to approve one or two drafts for structural reforms, possibly modelled on EU suggestions. If parliament approves, then Mr Renzi can go back to Brussels for a third time, show he has done his homework, and perhaps be allowed to break the fiscal compact without penalty.

Biggest problems

If parliament turns down the proposals, Mr Renzi will resign and Italy’s President Giorgio Napolitano will call new elections. A ‘technical government’ will be appointed to increase taxes regardless of its effects on the economy.

Italy is not the EU’s worst-performing economy. That prize goes to Croatia. But Italy is bound to become a test-case for scenarios which emerge for troubled economies which fail to rebound, find it difficult to raise taxes, and are unable to cut spending.
So which European countries apart from Italy face these prospects?

The Spanish economy has been considered one of the European Union’s biggest problems. But data during the past six months shows growth is gaining speed, fed by a significant rise in domestic demand. This usually reveals optimism for the future. Consumer prices fell 0.3 per cent (July 2013 to July 2014), which proves that if the fundamentals are sound and structural change has taken place – for example, the 2012 reforms in the labour market were crucial – competitive pressures are at work and deflation is not problem.

This does not mean that Spain’s problems are over. The six per cent public-deficit-to-GDP ratio is daunting. Unemployment is at a whopping 25 per cent, but falling, and the banking sector still looks fragile. But the immediate future certainly looks better than in 2012.

Pessimistic climate

Portugal is also showing some signs of structural improvement, despite the fragility of its banking sector and although the overall climate remains pessimistic. According to a recent poll from the European Commission, 96 per cent of Portuguese believe their economy is in a bad way and 85 per cent of the population has no confidence in the government. Portugal remains vulnerable, given a growth rate of about one per cent – lower than predicted at the beginning of 2014 – and a deficit/GDP ratio of six per cent.
Greece remains in a similar position. The Greek crisis has not been sufficient to persuade local policymakers to adopt substantial reforms. Instead, they have relied on the traditional fiscal remedies of tax rises and spending cuts. The outcome is similar to the Italian scenario – minimal growth and bad public finance, with a budget deficit close to 13 per cent of GDP.

France merits attention, too. President Francois Hollande is struggling with a stagnant economy when positive growth had been predicted, a budget deficit of about four per cent of GDP against a target of about 3.5 per cent, and rather gloomy expectations.
France – like Italy, Greece and Portugal – has also failed to bring about structural reforms. Time is running out, especially as the Spanish experience shows that it takes about two years before structural reforms translate into economic improvements and justify a change of economic climate.

Success story

Italy though remains a special case. It presents all the negative features together: It is not growing, has very high tax taxes, has failed to bring about structural reforms of any sort, business and households share a widespread pessimism for the future, and it has an important deadline to meet by the end of 2014 with the three per cent budget-deficit constraint.

France is like Italy except that it does not have to confront the European authorities at the end of 2014. Its deadline for meeting the three per cent target is December 2015.
Spain, however, could be a story of success. Although the economy is still burdened by very substantial problems, it has become more responsive to market incentives, its fundamentals are improving slowly, and it has no specific deadlines to meet.

Equally importantly, the impression is that Spain’s economic climate is significantly better than in the past. This means that should any shock occur, the European Union – and the European Central Bank (ECB) in particular – would come to the rescue.

Uneasy quiet

Greece and Portugal are in limbo. Their situations remain critical, even if recession is technically over. The chances of them engaging in serious reform are slim and ECB support is far from certain.

The most likely scenario for the next six months can be defined as ‘uneasy quiet’. ‘Quiet’ because – except for the Italian mess – no critical situation should emerge. ‘Uneasy’ because several economies remain fragile and clearly dependent on the promise of ECB support.

Italy will not collapse, but it is heading towards some kind of a crisis – economic, political, or both. The reaction of Brussels to such crisis could set a precedent, especially if it gives in to Mr Renzi’s requests and responds by postponing the fiscal deadline to 2015 or later.

We believe that there will be no postponement. Instead, major European actors will encourage Mr Renzi to step down to make room for a temporary technical government committed to squeezing the Italian taxpayers a little more. It will then be Mr Renzi’s business to win the elections with a majority large enough to implement the reforms inspired by Brussels.

If this mechanism worked, it could provide the straitjacket-template for badly performing countries in years to come. France, Greece and Portugal could be next.

This report has been written by Professor Enrico Colombatto and made available to our members through the courtecy of ©  Geopolitical Information Service AG, Vaduz

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