Courtesy Reuters

How Italy's Democracy Leads to Financial Crisis

An Economic History of Italian Politics

The replacement of former Italian Prime Minister Silvio Berlusconi with Mario Monti, a former European commissioner, last week marks a new stage in the European financial crisis. Along with bond values, the crisis now seems to be wiping out democratically elected governments. Faced with unbearable market pressure, Italian politicians have opted to hand power to technocrats, expecting that they will somehow enjoy greater legitimacy as they impose painful measures on an angry population. This will not work.

On one level, Italy's problems are less acute than those facing the region's other troubled economies. Its economic structure, which is based on a large manufacturing sector focused on exporting high-value products, has more in common with Germany than with Greece. The country has unparalleled cultural riches, a highly educated population, and a strong tradition of entrepreneurship. And despite its apparently dysfunctional institutions, Italy remains the eighth-largest economy in the world. On another level, Italy's problems are huge. Its debt-to-GDP ratio is massive; it has now reached 119 percent (although no one batted an eye when the ratio was 121 percent ten years ago). The markets seem convinced that its recent sclerotic growth has made the debt level unsustainable without structural reform. External observers have come up with long lists of such reforms, which, they argue, Monti will be able to implement quickly.

If things were that simple, however, Italians would have voted for someone like Monti in the first place. If anything, the last two decades have shown that there are no quick technocratic fixes for the Italian political economy.

Berlusconi rose to power in 1994, filling a vacuum in the center-right. That wing's main party had just been dismantled during an anticorruption drive by the Italian judiciary. Berlusconi hurried to create a new party, but he did not build a conventional one. Instead, he leveraged his television channels and national network of advertising salesmen to make a virtual party -- one with no real grass-roots membership, entirely dependent on his resources and patronage. Conservative Italian voters, fearful of the former Communists on the left, provided their consistent support despite his brazen manipulation of parliament for his personal benefit (witness the numerous legal reforms designed explicitly to hinder the work of prosecutors investigating Berlusconi and his companies).

Berlusconi's first center-right government collapsed after only seven months in office, however, because his coalition partner, the populist Northern League, withdrew its support in opposition to proposed pension reforms. Oscar Luigi Scalfaro, who was president at the time, called on Lamberto Dini, a former Bank of Italy executive, to form a center-left coalition caretaker government -- much like the one Monti is heading up now. During his tenure, Dini managed to pass major pension-reform legislation, which was seen as a sine qua non of joining the European Monetary Union. A year into the caretaker government, general elections were held and Italians voted in another a center-left coalition, this time under Romano Prodi, with former Bank of Italy Governor Carlo Azeglio Ciampi in the role of treasury minister. The Prodi government passed further fiscal stabilization measures, including a one-off "Eurotax" to ensure that Italy could meet its currency obligations under the Maastricht Treaty. In 1998, shortly after Italy's euro membership was confirmed, a small Communist group left Prodi's coalition, pulling the plug on his government. By the time the euro coinage came into circulation, Berlusconi had returned to power, promising "meno tasse per tutti" ("less taxes for everyone").

Under Berlusconi, the pace of fiscal stabilization slowed. Although he enjoyed a large majority in parliament, he made no progress at all in reducing debt, and Italy's growth rate stagnated. In 2006, Prodi was narrowly elected again on the back of popular disillusionment with Berlusconi's failure to deliver. Prodi's new center-left government lacked a cohesive parliamentary majority, but his finance minister, Tommaso Padoa-Schioppa, a former executive member of the European Central Bank, immediately set about reducing the deficit, increasing tax revenues by  11 billion euro in 2006. He did this largely through the simple expedient of applying existing tax law more vigorously. The deficit dropped quickly to just over one percent. This time, the Prodi government lasted a little more than 18 months. New elections in 2008 swept Berlusconi to power once more. His platform included, among other things, the abolition of the ICI (Imposta Comunale surgli Immobili), Italy's local property tax, and a state rescue of the bankrupt national airline Alitalia.

Monti's ascension therefore fits into Italy's established pattern of fiscal laxity under populist center-right administrations followed by briefer periods of technocratic austerity under the center-left. To be sure, Monti's interregnum is dealing with a tougher situation: Not only will he have to tap Italy's small businesses and self-employed professionals for extra taxes in the middle of a severe recession, he will also have to persuade the Italian unions to accept liberalizing reforms, pay cuts, and a later retirement age. The resulting squeeze on incomes will almost certainly reduce economic growth, making additional rounds of austerity measures a near certainty.

Even so, the bottom line of Italy's economic problems is no different now than it was two decades ago. They still have a fundamentally political cause, namely that there is no coherent electoral coalition that can sustainably support economic reform. After years with Berlusconi at its helm, the center-right lacks a coherent explanation for Italy's economic woes and usually defaults to resisting change. Already, Berlusconi's main coalition partner, the Northern League, has refused to support Monti. Berlusconi's own party, the People of Liberty, is disintegrating fast.

Meanwhile, the center-left is in an awkward position, too. It is centrist-oriented, pro-European, and favorable to liberalizing structural reform, but it has few members and a declining electoral base. Moreover, its support of austerity and liberalization will further demoralize its small core electorate, many of whom are the principal targets of likely reforms: pensioners, unionized blue-collar workers, and public-sector employees. On the far left, Nichi Vendola, the leader of the SEL (Left, Ecology, Liberty) party, recently tweeted that "big international banks have provoked the speculation in order to militarize our country from without," placing his commitment to tackling the country's internal problems in doubt. Meanwhile, popular mistrust of the political class in Italy is at an all-time high.

So, despite Monti's technocratic credentials, the professional politicians in parliament are unlikely to embrace extensive reforms of the kind the European Union advocates, for the very good reason that Italian voters are reluctant to vote for them. As in the past under Dini, far-reaching economic changes will be smuggled past the electorate during the caretaker period, or not at all.

In any case, structural reforms to enhance Italy's economic efficiency might improve the country's growth rate but, as the economist Nouriel Roubini has pointed out, they are likely to depress the economy still further in the short run. The main beneficiaries of this scenario will almost certainly be the populist forces on the far left and right. Umberto Bossi, head of the Northern League, ostensibly committed to the secession of a nebulously defined Padania region stretching from the Alps down to the southern edge of the Po Valley, supported Berlusconi for a decade but has already begun to reposition his party and exploit popular anger at the crisis. On the left, a political movement has gelled around the comedian Beppe Grillo (think of an Italian Bill Maher), whose popular tirades against la casta (the political class) offer a critique but no solutions. Blanket condemnation of the political class is a common sentiment, particularly among younger voters, who are less and less inclined to join mainstream political parties.

With general elections due in 2013 at the latest, it is difficult to imagine Italians doubling down on Monti's reforms and voting in a government with a clear mandate for political and economic restructuring. Indeed, with skepticism over the euro growing in Italy even before the crisis, it is not certain whether the new parliament will be committed to Italy's continued membership in the eurozone. Populists on the far right and left, faced with European pressure to make deep cuts in spending and radical reforms, may well opt to threaten default rather than punish their angry electorates.

There are reasons to stop the Italian political cycle. Italy's political future is the key to resolving the euro crisis more generally. If Germany does opt to bail out the country in one way or another, EU leaders will certainly demand commitments to economic reform in return. In the absence of radical changes to the European Union itself, however, there is no way to ensure these reforms are implemented now and in the future. Monti can offer a short-term guarantee that Italy will meet its obligations, but Bossi, Berlusconi, and even Grillo are all effective veto players. Moreover, if austerity measures have the same effect in Italy as they did on Greece, the graffiti will be on the wall not just for Italy but perhaps for the eurozone as a whole. Instead of punitive austerity measures, Europe needs to offer support to struggling southern governments to see them through this crisis, not just for financial and economic reasons but for political ones. Rewarding pro-euro governments like Monti's is the only chance to generate an electoral mandate for reform.

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