Eurozone: Divorce, Italian Style?

For all the jokes about Italian politics, Europe now seriously hangs on that country's upcoming election. Italy's vote on February 241 has the power either to calm or inflame the Continent's ongoing fiscal and financial crisis; and since this crisis periodically has rocked markets on both sides of the Atlantic, the vote also holds more than a passing interest for American investors. The vote will decide two issues of critical importance: 1) whether Rome continues to cooperate with Germany and the rest of Europe on budget restraint and 2) whether Italy will continue to lead the rest of Europe's periphery in pro-growth, structural reforms. Right now, the polls and the electoral maneuvering point to an acceptable, if not an especially encouraging, election outcome, one that could avoid the worst of these risks. But, as ever with politics, most especially Italian politics, matters are far from certain.

Italian cooperation with Europe is key. Because outgoing prime minister Mario Monti has, during the past 13 months, accepted the necessity of budget austerity, financial support from Germany and the eurozone has flowed and quelled questions of default or rescheduling.2 But if the election brings in a government that rejects such cooperation, Italy would almost certainly lose that support from the European Stability Mechanism, as well as that of the International Monetary Fund. With these monies withdrawn, Italian borrowing costs would rise immediately—so quickly (in all likelihood) and so high, that in short order the government in Rome would find itself unable to finance its own operations. The resulting default could force Italy out of the common currency. Worse, it would drive investors away from the bonds of other nations in Europe's beleaguered periphery, forcing up their borrowing costs and possibly driving them into default as well, despite how they otherwise may have committed themselves to cooperation and austerity. Such a chain reaction of failures could destroy the euro and precipitate a financial panic, perhaps even worse than those suffered periodically during the past three years or so.

Also hanging on this vote is Italy's recent, important embrace of pro-growth, structural reform. Faced with the unavoidable need for austerity, Monti turned to such reforms as the only way to promote growth without burdening the national budget. He worried, quite reasonably, that without such a growth strategy, Italy could fall into a vicious economic cycle in which the otherwise essential budget restraint deepens the recession, widens budget deficits, and elicits still more austerity that creates a still deeper recession. Accordingly, he led Rome's parliament to liberalize the nation's regulatory structures. In particular, Italy has altered its once highly restrictive labor laws to make it easier and less costly for firms to hire and fire workers, set work rules, and negotiate with unions locally instead of only on a national basis. Such efforts to improve business efficiency, dynamism, and competitiveness will, admittedly, generate growth only gradually, but, in the circumstance, the approach is all the country has to moderate the ill effects of otherwise essential budget austerity. If the February election shuts down the reform effort, Italy would suffer still more recessionary pressure. Since Italy's promotion of such liberalizing reform has served as a guide for the rest of Europe's periphery, backsliding by Rome could easily have an unfortunate echo elsewhere as well.

At present, the polls suggest that the vote will save Monti's efforts on both European cooperation and structural reform. Italy's Democratic Party supports them, and it currently leads in the polls, with almost 38% of the indicated vote.3 Though described as left-leaning and led by an ex-communist, Pier Luigi Bersani, the Democrats nonetheless have vowed very publicly to stick to the austerity program. Bersani has said that he would keep Monti's pension cuts and tax increases in place. He has even embraced German finance minister Wolfgang Schäuble's proposal to institute a "currency commission" that would govern the budgets of nations participating in the common currency. Equally important, Bersani has vowed to keep Monti's more liberal regulatory and labor laws intact, claiming credibility in such a commitment by pointing out how in the late 2000s, he, as minister of economic development, worked to advance pro-competition measures.4

Though prospects for a continuation of Monti's crucial policies look reasonably good, it also is clear that much remains in play. If, for instance, it seems to be a good bet that a Bersani government would retain the pro-growth structural reforms already advanced by Monti, it is not at all clear that it would improve economic prospects still more by extending them, or even if it wants to do so. Of course, Europe's common currency could survive an adverse vote or even an Italian disaster. Important as Italy is at this juncture, it still is not the whole story. But it would make matters much easier for Italy, and for Europe, and it would reduce the risk of financial panic if the election allows the country to continue down the path set by Monti.

1 "Berlusconi Forms Alliance in Comeback Bid," The Wall Street Journal, January 8, 2013.

2 "Italian Parties Romance Monti to Buoy Political Fortunes," The Wall Street Journal, December 19, 2012.

3 "Berlusconi Forms Alliance in Comeback Bid," op. cit.

4 "Italy Front-Runner Vows Steady Hand," The Wall Street Journal, December 10, 2012, and "Bersani Wants Growth-Oriented Europe," Financial Times, December 26, 2012.

© Lord Abbett

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