Instability will hinder Renzi's Italian job

Italy's recovery hinges on Prime Minister Matteo Renzi's ambitious reform program, but a fractious parliament and a fragile government coalition could prove a major stumbling block.

Italy's new prime minister Matteo Renzi presented his government agenda yesterday and is expected to win a vote of confidence in the Senate later in the day and in the Chamber of Deputies on today. In the past few days, Renzi promised to reduce state bureaucracy, cut payroll taxes, loosen employment rules, apply higher taxes on financial investments and approve public spending cuts.

But the new prime minister will be working under the same constraints as his predecessors. He will have to rely on a fractious Parliament and a fragile government coalition. This will undermine the new government's ambitious plans for reforms, since decision-making will remain difficult and slow.

While political instability in Italy is unlikely to affect the rest of the eurozone in the short term, it will keep weakening the country's prospects for a substantial economic recovery and contribute to a rise in anti-establishment sentiment.

During his speech at the Italian Senate on February 24, Renzi promised to apply four key reforms in four months: a new electoral law, revision of labour market legislation, public administration reform and an overhaul of Italy's tax system. He also proposed to reform the Italian Constitution, to modify the role of the Senate and to withdraw administrative powers from regional governments and enhance the central government. These promises definitely touch on some of Italy's key problems. The country's economic crisis is, to a large extent, the result of a fragile political system, excessive red tape and bureaucracy, a rigid labour market and a baroque fiscal system. However, the new prime minister will face substantial domestic and international constraints that will reduce his ability to implement these reforms.

International constraints will have limited influence

The international constraints are important but not insurmountable. The European Union is worried that Italy could breach the bloc's deficit and debt targets. At 130 percent of gross domestic product, Italy has the second-highest debt-to-GDP ratio in Europe, and public spending has been growing at a faster pace than fiscal revenue (according to Eurostat, Italy's total general government expenditure is at 50 percent of GDP, below France's 56.6 percent but above Germany's 44.7 percent).

Rome presented a budget for 2014 that was designed to keep the country's deficit below the 3 percent of GDP ratio established by EU legislation, and the Italian government is undertaking a spending review. However, Brussels is worried that the new government could break its promises. The fiscal compact treaty, which was designed to apply stronger control on national budgets, will enter into force in 2015, but several EU officials are worried that the pact will not be implemented effectively.

Graph for Instability will hinder Renzi's Italian job

While the European Union will pressure Rome to honour its commitments, this pressure will not be the main factor driving Renzi's decisions. Countries such as Spain and France have made it clear that targets and goals can be continually renegotiated with no significant repercussions from Brussels.

Some EU officials also suggested that the EU Commission could be flexible with Italy if Rome presented a comprehensive reform program. On the weekend, Renzi spoke with German Chancellor Angela Merkel and agreed to visit Berlin in mid-March to discuss his plans. Italy will likely be able to manage its relationship with the European Union and avoid extreme pressure from Brussels.

Rome could feel some pressure from international markets, but things have substantially calmed down since the European Central Bank promised to intervene in debt markets if need be. It is extremely unlikely that Brussels would decide to teach Italy a lesson and withdraw its promise of assistance. The whole system was created to help Italy. In November 2011, as former Italian Prime Minister Silvio Berlusconi was asked to step down, Italian banker and economist Mario Draghi was named president of the European Central Bank. To a large extent, Draghi's promise of intervention brought Italian bond yields down, as well as Portuguese, Spanish and Irish bond yields. This is one of the few EU policies that has actually worked, so no change is expected on this front.

Domestic pressure poses real challenges

Renzi will be under considerably more pressure domestically. The new prime minister will have to deal with implacable opposition from two populist adversaries: Five Star Movement leader Beppe Grillo and Forza Italia leader Silvio Berlusconi. Both will intensify their anti-taxes and anti-European rhetoric, blaming Renzi for acquiescing to German pressure. This rhetoric will escalate in coming months, reaching its highest point in the weeks before the EU Parliament elections in late May. Grillo and Berlusconi will appeal to the growing number of Italians who are feeling the impact of the economic crisis and are disenchanted with the Italian government.

Italy's geographic challenge

Renzi will also feel pressure from within his own center-left Democratic Party because some of its members do not support the prime minister. The left wing of the Democratic Party will push Renzi to ignore pressure from Brussels and try to weaken Renzi's labour reform by pushing for the preservation of those measures that protect workers from unjustified dismissal. But Renzi will also be under pressure from his coalition partners in the New Center Right, which wants reduced taxes for companies and households. So Rome will be under pressure to lower taxes and reduce public spending (but not too much, since it would agitate voters and the left wing of the Democratic Party) while honouring its promises to Brussels.

As a result, Renzi's main constraints will not come from Europe but from the Italian Parliament. Italy changed its prime minister, but the composition of the Parliament (where no party can govern on its own) remained mostly unchanged.

Italian politicians decided not to hold elections to avoid facing the unpredictable reaction of voters. By doing so, they ensured stability in the short term but also prolonged the stalemate in Parliament. Renzi will be dealing with exactly the same Parliament that blocked his predecessor's government. The fragile coalition between the Democratic Party and the center-right slowed decision-making in 2013, and the situation remains largely unchanged.

This situation makes it unlikely that Renzi will meet his reform schedule. While some reforms will probably be approved – most notably, the reform of the electoral law – others will be delayed and toned down to meet the contradictory demands of the ruling coalition. Political infighting will be as frequent under Renzi's leadership as it was during the governments of Mario Monti and Enrico Letta and will continue to undermine the effectiveness of Italy's government. Despite his promise to head the government until the end of the current legislature in 2018, it is unlikely that Renzi will remain in power that long.

The financial aspect of the European crisis has become a somewhat secondary concern. Ireland's bailout ended last month and Portugal's ends in May; Greece could receive additional help later in the year and the European Central Bank has successfully calmed debt markets. Uncertainty could return in late 2014 or early 2015, when the results of the stress tests on European banks are released. In the meantime, the prospect of a new escalation of the financial side of the eurozone crisis seems unlikely. This means that Italy's political instability will not be as threatening to the rest of the eurozone as it was two years ago.

As a result, the main consequences of Italy's instability will be felt at home, where protests will remain frequent and anti-establishment sentiment will remain high. Without a significant redistribution of power in Parliament, which is impossible without new elections, any government in Rome will be very limited in its capacity to apply reforms. Mainstream political parties will try to avoid new elections for as long as possible, but they will not be able to hold off indefinitely. In this context, new elections will probably take place long before the end of the current legislature in 2018. Republished with permission of STRATFOR.

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