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What Italy Can Expect after Monti

Protesters with a caricature of Spanish PM Rajoy march during a strike in Pontevedra (REUTERS/Miguel Vidal).

Most observers hold Italy as the make-or-break case of the eurocrisis and look anxiously at what will happen in Italian politics once the current government ends its mandate. The coming election, presumably in March of 2013, may indeed be critical, although not for the kind of political uncertainty that we generally associate with high-stake elections, but for the opposite reason. What the ballots may actually reveal is how limited the scope is for national politics in the new European institutional setting forged by the crisis.

Twelve months have now passed since Mario Monti took the responsibility of a non-partisan, or “technical”, government, and Italy has become reassuringly boring. In that time Prime Minister Monti has advanced in his rather severe mission of lending some credibility to Italian policymaking and has been a very influential player in the European negotiations. Further financial turmoil in the euro area has been averted also through Monti's policies that have proved more credible and consistent than those of his predecessors. Recently the drain of capital has reversed and foreign investments are flowing back to Italy, albeit moderately.

Nevertheless, the economy has continued to fall faster than expected. After four years of crisis, the loss of almost 30% of Italian industrial capacity has become structural. Consequently, if growth is not restored rapidly, the persistent recession will put the fiscal position of the country at risk. Not because fiscal policy is out of line, but because the GDP--the denominator in the debt-GDP ratio--is declining.

A lack of understanding of the new European arrangements and of how intrusive they can be in national politics has left foreign analysts scared by the fiscal policy uncertainty following the next election and after Monti. In many cases, both in the US and across Europe, policymakers look at the end of the current Italian government with outright angst. The country is too big to be saved and in the recent past it has indulged in financial and political instability. Although the doubts surrounding Italian fiscal probity are widely exaggerated, the fears of its economic collapse, unfortunately, are not.

The new European fiscal rules, carved into the "fiscal compact" treaty now being adopted by most EU countries, in fact, are enough to keep any "non-Monti" government on the track of fiscal discipline. A subsequent government may be more inclined to spend or more inclined to reduce taxes, more prone to European rhetoric or rather more nationalistic, but eventually the structural budget balance--net of the ups and downs of the economic cycle--will have a lower limit for the structural deficit of 0.5% of GDP, as mandated by the "reinforced golden rule" contained in the treaty. And this, along with an external balance close to equilibrium, is all that matters to partner countries that want primarily to avoid paying the Italian public debt bill in the near future.

But, what happens if the elections change the character of the government radically? In recent years incumbent governments in the eurozone have been persistently thrashed at the polls. According to recent opinion polls, Italian electors have a mixed judgment on the current government and have cultivated a sense of rebellion towards the political establishment at large. But the fact remains that the financial decisions of the next government have already been made. The double imperative of balancing the budget and reducing the ratio of government debt to GDP (annual cut of 5% of the debt exceeding 60% of GDP) has been approved by the Italian Parliament and by those of the other countries, becoming part of an international treaty – the fiscal compact.

This treaty provides that “in the event of a significant observed deviation from the medium-term objective of the adjustment path” a correction mechanism shall be triggered automatically. Controls and sanctions, up to the appeal to the Court of Justice of the European Union, will enforce the imposition of lump sums or penalty payments in a much more stringent way than in the past.

Wiggling out of this legal construction is not only difficult, but even discussing such an eventuality can be problematic. Once a “non-Monti” government reveals any intention not to comply with the fiscal agreements, or as soon as the Parliament expresses the wish to denounce the Treaty, the country's fiscal position will deteriorate. In fact, investors will be afraid to buy the government bonds of a country whose future fiscal soundness is questioned by its own institutions.

Furthermore, the fiscal compact was introduced as a counterpart for the creditor countries to convince them to share more resources in the common funds that give financial assistance to the ailing countries. The text of the Treaty clearly states that "the granting of financial assistance in the framework of new Programmes under the European Stability Mechanism will be conditional, as of 1 March 2013 (10 days before the most likely date for the Italian election) on the ratification of this Treaty”.

If the “fiscal compact” loses an important country like Italy, the fund in question (the ESM) would most likely be canceled. It would be the end of the single currency. Those Italian fringe parties that are vocally critical of both budgetary rigor and the euro have a tragic consistency. But this corners them in a very difficult position as they are characterized as extreme political formations that are not offering a realistic program.

If the next Italian Parliament does not want to leave the euro, then the "non-Monti" government’s room for maneuver in public finance is rather low, if not nonexistent. It remains, however, to discuss instead the quality and structure of the budget. In fact, every time the current “technical” ministers make awkward or wrong decisions (significant mistakes were made in one aspect of the pension reform, while serious problems emerged in the labor market reform, in the proposed reform of the school system and in the initial design of the Budget Law), they justify them in their hope that more political choices in the future can improve the understanding of the reality of Italian society by those who govern it. But even in the case of a rehabilitation of the political parties, the degree of freedom that the new government will enjoy is smaller than generally assumed and relates mainly to the quality of decisions (paradoxically to their "technical" nature) rather than the ideological footprint.

Parties will still campaign and reap votes by promising a revolution in the ratio between taxes and public spending, particularly if they tell their electors only the benevolent half of the story, promising only tax cuts. Alternatively, they can defend the newly fashionable "balanced budget theorem" (growth by an equal increase in spending and taxes) and promise a more generous welfare package. However, the Budget law of a "non-Monti" government must still be submitted, first of all, to the judgment of the partner countries and EU institutions, even before it is discussed and voted by the Italian Parliament. The Law will need to be considered credible by the EU institutions in terms of its compliance with the annual target toward a balanced budget. In respect of the application of the fiscal balance rule , set out in article 3 of the Treaty, the EU Commission will monitor the compliance through country-specific medium term objectives and a calendar of convergence.

Moreover, according to the fiscal compact, all major economic policy reforms in one country must be discussed ex-ante with the other member states and the Brussels institutions and, where possible, coordinated among the countries of the euro area. This is particularly interesting because any radical revision, politically inspired, should manage to collect the support of the other EU partners. However, given the diversity of political orientation among the partners, it is highly unlikely that they will agree on a very radical agenda in one of the member states.

Furthermore, in order not to violate the annual targets, radical policy strategies need to be smoothed out as gradual processes, consistent and continued over long periods. Necessarily they would need to last multiple years, perhaps longer than a single legislature. This is a serious constraint for any ideological overtone, because, by increasing the likelihood that the law would be revoked at the first change of majority or electoral appointment, ideological policies would be less stable and therefore less credible. This is the main rationale behind the current vogue pushing for “grand coalitions” across Europe.

Finally, should radical political change occur and bring a country's budgetary position out of line, the EU would put in place a suavely named "budgetary and economic partnership program". The mechanism would actually put the diverging country under strict surveillance and require a detailed description of the structural reforms that the government would have to implement--all of this carried out under constant EU monitoring.
But wasn't this control already in place in the past, and didn't it prove blatantly ineffective? Yes, but now, markets are no longer anesthetisized, and partner governments are once again alive and kicking as well. And the Treaty offers them a powerful new weapon: Any country adhering to the Treaty can bring another country that is supposedly violating the Treaty in front of the EU Court of Justice and request the imposition of financial sanctions. This is possible independently from the initiatives of the European Commission. In the deteriorated diplomatic environment caused by the European crisis, it is not difficult to imagine one of the creditor countries moving its legal armies to the Court in Luxembourg. In fact there is a lot of populistic potential behind fiscal rigor (in other countries).

So, strong control from abroad, no fiscal leeway and no ideological leverage. Deprived of room for maneuver both in its theory and its practice, the "non-Monti" government should wager everything on forging "a different climate in Europe," denouncing the failure of austerity policies in all countries and the lack of economic and fiscal coordination among the 17 member states. In the past, a request for less austerity might have worked, and actually did work, but now investors are ready to jump ships that are massively loaded. In the past weeks it was enough for Berlin to put just a little informal public pressure on French President Hollande to let France become a target for speculation.

Yet, a questioning of the European status quo will be inescapable for the coming government, and necessary not only for Italy. The balance of power between those countries that enjoy the confidence of markets and those countries that do not is so out of line that it has caused a new form of democratic deficit in Europe. In the meantime the European public discourse has been damaged so severely that the historical truth of the crisis and its causes has been disregarded and needs now to be restored if we want to give back to the citizens a positive sense of Europe.

From a more pragmatic point of view, the new Italian government needs to develop a European strategy to avoid a deeper recession and avert the dangerous debt-deflation spiral that is underway. Since fiscal policy cannot be used, monetary policy is not available at a national level and structural reforms are not helping stop the economy’s decline, Italy needs an external stimulus coming from a growth initiative in Europe. The export oriented industrial sector is still thriving and would profit from an increase in the economic activity abroad. Consequently, in order to restore growth, Italy needs to change the nature of the current economic cooperation in the euro area that is based solely on preventive distrust and fiscal austerity. This has clearly proved not to work and is deepening--not alleviating--the fiscal crisis. Furthermore the spiral of austerity is drawing in all of Europe. Even the stronger economies, from the Netherlands to Germany, are now balking. So a new Italian government will have to reconsider the way the euro area deals, or does not deal, with its depressed level of activity.

However, to renegotiate the European framework, a government must be credible in Brussels. And in order to be credible there it needs to conduct credible policies at home. In the current juncture, for instance, if President Hollande had a balanced budget, he would be politically stronger than Chancellor Merkel. In order to be effective in Brussels, a "non-Monti" government in Italy would wind up behaving more or less the same way as the real Monti government. Perhaps it would enjoy even less wiggle room, as it will have to build its own credibility from scratch. For this reason, political analysts in Italy believe that no matter the government “post-Monti”, it actually means Monti.

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