Why Italy must reform

By: Wolfgang Munchau

Four months ago, Romano Prodi stumbled to power in Italy on a platform of economic modernisation. Shortly after his election victory, I argued in a column that Italy's long-term participation in the eurozone would be in doubt unless Mr Prodi managed to enact an improbable amount of radical reforms.

My Italian friends assured me that the country's long-term future in the eurozone was a lot brighter than I suggested. All it took were some well targeted economic reforms to raise productivity and modernise the budget. Sure, the task would be formidable, but there was no need to panic. All this reminded me of a comment attributed to Winston Churchill: “Tomorrow, I’ll be sober.”

It is too early to pass a definitive judgment on the Prodi government. Mr Prodi has had a good start with the launch of much-needed service sector reforms. Pharmacists and notaries at last face some competition.

He has also been lucky. He took over during a mild economic recovery. Tax revenues during the first half of this year were almost 11 per cent higher than during the same period in 2005. In theory, the tax windfall should give Mr Prodi more room for manoeuvre. In practice, it will give him less. This week, Tommaso Padoa-Schioppa, the economy minister and former European central banker, said the extra tax revenues would allow the government to cut spending by only €30bn ($38.5bn) – instead of the previously agreed €35bn. About €15bn has already been earmarked for cuts in indirect labour costs and other measures to boost growth. This leaves a net saving of about €15bn.

This is about 1.1 per cent of Italy’s gross domestic product – not a figure to be scoffed at. But given Italy’s net debt of more than 107 per cent of GDP and its estimated deficit-to-GDP ratio of 4 per cent this year, this deficit reduction may not be sufficient, unless it is fully structural and followed by additional structural cuts of similar size in subsequent years.

This is far from clear. It is not even clear whether Mr Prodi can deliver this less ambitious package. He holds a wafer-thin majority in the senate and there are already signs of discord in his nine-party coalition.

Much of the focus in the Italian debate is on whether and when the country can meet the 3 per cent deficit-to-GDP target, the ceiling set in the Maastricht Treaty. But since Italy is going through a cyclical recovery, it should be running a balanced budget or even a surplus by 2007. We should not have a 3 per cent debate at this point in the economic cycle.

Italy’s fiscal policy has recently given rise to an illuminating and public e-mail exchange between
Mr Padoa-Schioppa and Francesco Giavazzi, professor of economics at Milan’s Bocconi University. In his regular column in the Corriere della Sera newspaper, Professor Giavazzi accused Mr Padoa-Schioppa of failing to cut the budget deficit sufficiently. He said export-led economies such as Italy and Germany should prepare for an eventual slowdown in US economic growth. Part of an optimal response would be a reduction in the deficit and a cut in taxes to encourage private consumption and investment.

He criticised Mr Padoa-Schioppa for failing to show enough deficit-cutting gusto. Mr Padoa-Schioppa responded with an ill-tempered e-mail, blind-copied to 92 others – politicians, economists, journalists – defending his record. “You don’t want reforms, but cuts, an expression equally embraced by the demagogues of simple change and the preservers of the status quo,” he wrote. Prof Giavazzi told me later that there was ample room for additional cuts in discretionary spending, even if one excluded sensitive areas such as health or pensions. On his calculations, general government spending minus interest, health and pensions went up from 16.4 per cent of GDP in 2001 to 17.6 per cent in 2005, equivalent to annual growth of 6.2 per cent. That portion of spending went up by almost 4 per cent in real terms each year.

The two have since patched up their differences. But this episode still leaves a strange aftertaste. One can only deduce from the tone of Mr Padoa-Schioppa’s response that the task of running Italy’s economy is even more difficult than expected.

The turnround of Italy’s economy would be an enormous task even at the best of times. Italy suffers from a myriad of economic problems: an unsustainable level of public debt; low productivity; a malfunctioning civil service; a hopelessly protected banking sector; an underdeveloped services industry; a specialisation in those areas of manufacturing that leave the country vulnerable to cheap imports from Asia; and wage and price setting mechanisms that encourage inflation persistence. Even if this mini boom were to turn into something bigger, it would not solve any of those problems.

There are few countries in the European Union where political support for the euro is as strong as in Italy. But membership of the eurozone will become unbearable unless Italy sorts out these problems. Mr Prodi and Mr Padoa-Schioppa probably do the best they can, given the circumstances. It is not clear at this point whether that will be enough.

Copyright The Financial Times Limited 2006