The next Italian government faces a double challenge. It is expected to keep order in public finance, as the other governments of the past 20 years, and to rekindle growth, as none of the past governments has succeeded in doing. Consequently its agenda will have to be gauged on the basis of three main elements: its adherence to the European fiscal compact; its ability to work with the EU institutions to solve the credit crunch underway; its reform plans aimed at helping Italian producers urgently achieve higher productivity and return to the export performances of the past.
In order to endorse and implement this ambitious as well as indispensable agenda, the political framework of the next legislature needs to grant a sense of urgency while ensuring stability. The outcome of today’s election is exactly the opposite. Given the provisional results on Monday evening, all three requisites are missed: There is no plausible majority in the Parliament; the parties more opposed to respect European commitments have become much stronger than at any time in the past; and the political stalemate does not bode well for economic reforms for which no majority has a mandate.
According to Monday night’s provisional results, the majority of the Chamber of Deputies will go to the left-of-the-center Partito Democratico, while the Senate will have no possible majority. Hence, there is no “governabilità” in the Italian Parliament. As a consequence, the new legislature will be uncertain and short. Its hallmark will be the “lowest common denominator” among inhomogeneous parties, both in the institutional and economic domains.
At a more profound level, the message delivered by the vote is a widespread popular protest against politics, similar to what happened in Greece in the last elections. The pillars of Italy’s politics of the last 20 years – a pro-European outlook and, fiscal austerity, in particular – have become negative qualities in this break with Italian post-war historical tradition.
Although Italy has to reconstruct a political narrative, just as Greece did, this does not mean that it will break free from Europe. The opposite is true. My estimate is that restoring normality in the credit market and lowering the cost of loans for the private economy is far more effective (the elasticity of the demand would be about three times higher) in stimulating the Italian economy than cutting taxes. In this light, European politics presiding over the solution of the crisis is more important than domestic policy.
Furthermore, the current political stalemate crystallizes the fact that the national Parliament is far from playing a central role in the management of the country. Executive preeminence over the legislative, the lack of political party credibility and the strong influence of European legislation have put the Parliament in a marginal institutional position. The same has happened over the past 15 months when a non-elected “technical” government, led by Mario Monti, brought the country out of its darkest hour. After the failure to achieve a clear parliamentarian majority, the outcome of the elections might be some form of non partisan “institutional” government that will be called on to conduct the country through a new electoral law and new elections. In this scenario, the political economy will be cautious, the European commitments will be observed and the new electoral law will be proportional. It will be the year of the lowest common denominator.
Voting in the midst of a recession
Today’s Italian election was not like any of the past elections. The reason is that Italians had never voted before in the midst of a recession as severe as the current one. Italian GDP has declined by about 9% since the beginning of 2008. In terms of purchasing power, the average disposable income of Italian households has plunged back to the level of 27 years ago. Consumptions have gone back to the levels of 1995. Unemployment is officially at 11%, up from 7% in 2008. But total underemployed labor force is around 21%. In terms of GDP losses, none of the larger European countries has been affected by the global financial crisis and by its European consequences as profoundly as Italy, not even Spain. Such a damaged economic context represents an unprecedented challenge for the democratic choice of legislative leadership.
The fundamental weakness of Italy’s fiscal position has caused Italian citizens to be more critical of the State and policymakers. In fact, this weakness, mainly derived by irresponsible policymaking in the 80’s, has prevented the State from addressing the collapse of GDP through stimulative demand policies. Given the fiscal nature of the crisis in other euro-zone countries – and the risk of contagion arising from those countries - Italy’s governments have been forced to implement austere fiscal policies during a recession. Between 2007 and 2012 the debt/GDP ratio in the 27 EU countries increased from 59% to 87% of GDP, while it increased from 103% to 126% in Italy. The difference, amounting to 5% of GDP, explains a large part of the growth differential accumulated by Italy relative to the other countries. Between 2011 and 2013 the Italian fiscal correction will amount to 5% of GDP. Italy is now the second country in the euro area with the highest tax on GDP ratio. Before 2008 Italy had seen its public debt decline from 126% to 103%. As a consequence of the global financial crisis and of its European consequences the public debt has returned to 126%. Italy’s banking system entered the crisis as the most solid in the euro area, but the procrastination of the crisis has now weakened it. The lack of an honest narrative for the euro crisis at the European level has left the painful policies caused by the worsening of the economic situation unexplained. This lack of consistency between causes and consequences of the crisis has stoked sentiments of frustration among the citizens. Furthermore the relation between Italian taxpayers and the State representatives was damaged by the pain caused by the austerity measures that had been implemented, more or less consistently, during the past 20 years. The fact that “fiscal sacrifices” have not brought Italy out of the crisis has produced further potential for political dissatisfaction.
In the past two decades, unsuccessful policymaking and austerity have fostered the success of political factions that feed on anti-political feelings and populism. In fact, Silvio Berlusconi has emerged as an anti-political leader since the early ‘90s. As such he has often found himself in a paradoxical win-win situation: he could reap benefit from his voters’ dissatisfaction with politics despite – or sometimes just because of – his poor performance as a politician.
However, this time the political framework was different from those of the past elections, and not only as a consequence of the current economic recession. In fact, Italians have never voted while facing more recession down the road, as it is the case now, with an expected decline of GDP by 1% in 2013. While Germany projects a stable economy this year, Italy faces more recession. The bleak perspectives have political consequences. If we define populism as “overpromising”, then there is no reason for rosy perspectives to be credible. In other words, traditional populism is not on fertile ground when a country faces the certainty of more recession.
Recrimination and Anger
In this environment the main sentiments are those of recrimination and anger. Indeed radical feelings about politics and dishonesty have been affecting the electoral contest in both destructive and constructive ways. On the one hand, political leaders have not easily advanced their visions of the future, but have preferred dwelling instead on the past (blaming Berlusconi or Monti or both); on the other hand, parties have finally taken stock of popular anti-political feelings in a rational way, for instance the lists of candidates have been purged and more than 50% of the new MPs will have never had public office before.
At the beginning of the electoral campaign, recession and widespread popular dissatisfaction produced a political environment that was indisputably favorable to the Left and to the anti-establishment parties. Before February 9, when electoral law imposed a suspension of polls’ publication, the last surveys showed Bersani’s Left Coalition (Partito Democratico and SEL) at 34%; Berlusconi’s Right coalition (PDL, Lega and others) at 23%; Monti’s Center at 15%; the two radical anti-establishment leftist parties, led by Grillo and Ingroia, respectively at 15% and 5%.
However, since the beginning of February, the Italian electoral campaign has been hit by what an American political analyst would call a string of “October surprises”. The first bit of unexpected news concerned the solidity of the third largest credit institution of the country, Monte dei Paschi di Siena, which is now jeopardized by a crass case of mismanagement in its derivative operations. The bank became the symbol of murky relations between financial interests and political personnel close to the Partito Democratico (PD). In the first ten days of February the news about the scandal-prone bank moved 5% of the electorate. Overall the impact has still to be gauged properly in the light of successive scandals emerging day after day and involving different parties and also private industries. A familiar unease emerged in the Italian public opinion as business scandals appeared intertwined with abuses in national, regional and municipal politics.
Monte dei Paschi caused a shockwave because it touched exactly on the raw nerves of the electorate: anti-political feelings and economic mismanagement. It was immediately clear that Monte dei Paschi was going to have a long lasting effect on the polls – eroding consensus for PD, which was directly involved in the bank’s management – and more indirectly on Prime Minister Mario Monti, given his assumed familiarity with financial milieus. In 2005-6 a similar case (Unipol) changed the electoral tide in favor of Berlusconi. In fact Berlusconi immediately tried to profit from the weakness of his opponents, resorting to generous promises of tax reimbursements. Berlusconi’s party staged a resurgence that brought it from the meagre levels of the beginning of the campaign (13%) to 20%. However, after the first wave of media reactions, Berlusconi’s comeback seemed to slow down, while anger remained up and rising, but looking for new political expressions.
The last two weeks of electoral campaign also staged the emergence of the “Movimento 5 stelle” led by the famous entertainer Beppe Grillo, who has voiced strong social criticism against the traditional parties and the establishment. Mario Monti, the incumbent Prime Minister, whose surprising decision to run was based on the expectation that Berlusconi’s party had disintegrated, found himself in a very inconvenient position as target of all dissatisfactions: social hardships, voiced by the Partito Democratico and by the radical Left; fiscal populism and anti-Europeanism provoked by Berlusconi; anti-establishment sentiments and juvenile protests bandied about by Grillo. Grillo in particular has been able to tap the unprecedented reservoir of undecided electors, many of whom had been tempted by abstention.
On February 9, 43% of the electors were still undecided. The dispersion of party support across the polls was noticeable. In the following weeks even the hierarchy among the major parties seemed to be in question. Although the Democratic Party was unanimously seen as the winner, getting the majority at the Chamber of Deputies, the second place was seen as a matter of contention between Grillo and Berlusconi. Given the peculiarities of the electoral law, the run for the Senate, the upper Chamber in the bicameral system, was even more uncertain. Control of both chambers is essential for implementing reforms and for the stability of the government.
The current electoral law was designed by Berlusconi in 2005 to avoid stable majorities at a time when the Left seemed close to winning the elections. In fact the law is designed to avoid the formation of a clear majority in the Senate where each of the 315 senators is elected through a regional vote, with the 20 regions as constituencies. In order to control the Senate, the Partito Democratico should have won at least 158 seats and specifically it needed to win at least three of the four uncertain regions of Lombardy, Veneto, Campania and Sicily. It lost all of them to Berlusconi allowing him to become the first party at the Senate.
This time there is no margin for Grand Coalition
In order to understand how critical the multi-party negotiations are, one needs to dive into some details of Italy’s required economic restructuring. During the crisis, Italy lost 25% of its industrial capacity in the past 4.5 years. After such a long period of idleness, those jobs are gone forever. The loss of “potential capacity” will not be restored even if a more benign economic cycle is restarted. In other words, due to the length of the crisis Italy has suffered a structural loss in its potential GDP. On the other hand Italy has 3000-4000 firms that are still performing amazingly well on the global markets. They are keeping the country afloat, but they urgently need easier access to credit and more labor flexibility. In particular, labor flexibility is needed to encourage the 3000-4000 firms to hire hundreds of thousands of unemployed Italian workers and not to move production elsewhere. Labor flexibility of this kind runs against the agenda of Partito Democratico. Bersani owes his nomination as party leader to the support of the most popular and conservative trade union, the CGIL. This union is a bastion against more radical leftwing parties. So even if Bersani is a moderate and open minded leader, he has little room of maneuver: he will be hard pressed from the Left and threatened by a new generation inside his party. Berlusconi did not manage to find a solution to the crisis when he governed the country. Although he has governed for at least ten of the last 18 years, he has never been able to implement the tax cuts that were the cornerstone of his electoral programs. On the other side, Monti has been adamant during the electoral campaign in saying that he will not join a government under the auspices of the CGIL and a euro-skeptic Berlusconi.
While the GDP gap between Italy and the other euro partners has widened since the crisis started, the brunt has been born by industrial manufacturers that in 2008 were on the verge of a technological transformation similar to the one that had proven so successful in Germany in the Nineties. It was by no means a sure thing that the transformation would succeed, given the fact that the delay in productivity was getting bigger year by year. Not only had the Italian GDP increased by a mere 4.2% between 2000 and 2011, against 16.5% in the rest of the EU, but hourly productivity in 2011 was only 1.6% higher than in 2000, against an increase of 13.9% in the rest of the EU. Italy actually posted the lowest increase in productivity among the 27 EU countries.
Essentially, Italy’s capitalism has faced a double challenge that it has never been able to fully address. The first has been the reshuffling of European - and particularly German - industrial supply chains to Eastern Europe after the fall of the Berlin Wall and the enlargement of the EU. This historical change has shifted industrial production away from Italy, the second largest manufacturing powerhouse in the EU, to the new member states. The second challenge is that Italian producers never really adjusted to the era of a fixed exchange rate created by the European Monetary Union. Starting in 1994, Italy’s exports - that were more ebullient than in the other European countries during the period between 1950 and 1990 – lost touch with the rest of the euro area and started declining. Currency devaluations had benefitted mainly producers of low added value goods, whose demand has a higher elasticity to the price and consequently to its currency denomination The productive structure in Italy struggled to move upscale on a range of products with higher added value. In fact probably the opposite happened between 2005 and 2008 when the so called “unobserved economy” – part of which is outright illegal – increased by an astonishing 6.4% of GDP, showing probably that the structure of costs of production in Italy was too heavy and “needed” to avoid taxation and bureaucratic costs to survive.
The loss in productivity is well explained by the modest level of investment in tangible capital that was lower in Italy than in the rest of the EU. Particularly disappointing is the level of expenditure, both private and public, in research and development. The contribution of Total Factor Productivity – labor organization, labor formation, innovation of the productive process, quality of investments and most importantly economies of scale, given the small size of Italian firms - has even been negative. Labor force employment has remained almost 5 points lower that the European average at 56.9% due to the very weak contribution by female workers (46.9% of the total female labor force). Youth unemployment is at almost 20%, still lower than in 2004 (24.4%).
The growth problem of the Italian economy is clearly rooted in its low productivity. Hence it is likely to need urgent reforms on the supply side - in the use of capital and labor – that should emerge in the political context of a wide program of reforms involving a multitude of social partners and political parties driven by the priority of competitiveness. This is exactly the bone of contention between Monti who is in favor of a grand coalition for all-round structural reform, Bersani who is preeminently sensitive to the reasons of trade unions and of employment and Berlusconi whose focus is entirely on the level of taxation on firms. The electoral campaign has indeed focused on taxation.
First priority is to end the suffocating credit crunch
Good relations with the European partners are essential because of a specific problem of the Italian economy – credit crunch – that can be solved only through an innovation in the cooperation with the EU institutions. In fact, the persistence of the crisis in Italy, and possibly in the euro-zone, has been significantly underestimated in the last six months. In focusing exclusively on the fiscal nature of the crisis, it was generally assumed that strengthening fiscal rules and letting local banks buy government bonds with financing from the European Central Bank (ECB), would have been sufficient to bring the crisis under control and rekindle the economy.
The idea was that once fiscal fears had been assuaged, the whole structure of interest rates would fall in line with the declining cost of servicing the public debt. Ultimately, the economy would benefit from renewed credit supply and demand. Unfortunately, this simple scheme, dictated by the fiscal rhetoric on the causes of the crisis and by the avoidance of mutualization, has not worked.
The political project behind the euro has been substantially weakened by the prolonged crisis. So, without a strong and tangible political commitment, the economies – and particularly the financial systems – have remained fragmented, forcing new cracks in the European foundation. In the twelve months before June 2012, when Mario Draghi announced that the ECB would do “whatever it takes” to save the euro, Spain experienced a capital outflow equivalent to more than a quarter of its GDP. In Italy, outflows amounted to almost one-sixth of its aggregate income. The departure of foreign investors from periphery bond markets caused a large share of these flows, especially in Italy in late 2011 when the government, then led by Silvio Berlusconi, seemed paralyzed and dysfunctional.
Between late July and mid-September 2012, when Mario Draghi announced the OMT program, Spanish and Italian 10-year government bond spreads fell by about 130 basis points, the euro appreciated 7 percent against the U.S. dollar, and periphery equities rose by 30 percent. The intensity of the crisis, reflected by the government bond spreads, had weakened markedly as capital outflows from the periphery to the core stopped and even inverted direction, albeit moderately. In fact, except for the positive signs exhibited by the government bond market, the fragmentation in financial markets continued across the euro area.
In the context of intense deleveraging pressures, most European banks have kept trying to limit their exposure in the most fragile countries of the periphery. The consequence has been painful: the decline in credit supply has generated a dangerous and vicious cycle of continued credit crunches and economic recession. The protracted character of the 4-5 year-long crisis has given strength to destructive forces that go far beyond the stability of public budgets and affect the destruction of industrial capacity, the functionality of the banking system and the supply of credit to the economy.
The destructive elements of political inertia, banking instability and weak growth proved to be inextricably connected. As soon as Draghi announced the ECB plan for OMTs, political complacency set in. In October of last year, a proposed banking union was put on the backburner while strong opposition emerged against allowing the ESM to fund Spanish banks. The supply of credit in the periphery declined and the recessionary dynamic was implicitly accepted as a necessary cost of repairing the competitiveness of countries showing deficits in their balance of payments.
Month after month, although the spreads on government bonds were declining, a feedback loop started again: the recessionary forces remained intact and the lack of growth reverberated not only in the dubious solidity of many banks, but also in the shaky political stability of the countries that were most affected by the crisis.
As it affects the functionality of the interbank market, uncertainty about the status of the banking system is a critical component of the mistrust that prevents capital flows from spreading across the euro zone. If foreign investors continue to reduce their exposure in the periphery, several governments could face serious problems in funding their budgets, alternatively, lending to the private sector may be crowded out, making current recessions even more severe. According to the IMF, “The pullback of foreign investors has indeed been mirrored by falling credit to the private sector and a simultaneous significant increase in local banks holdings of local government bonds. Credit dynamics are the best indicators that the government bond crisis is changing its nature and becoming an economic crisis, potentially even more difficult to contrast.
The decrease in credit supply to the periphery is substantial and affects perhaps one-sixth of the total credit available to those countries. This means that unless the ECB channel for banking refinance remains open indefinitely, interest rates in the periphery will remain at levels that are ultimately incompatible with the sustainability of public debt in a weak economy. The contagion stemming from the periphery would spread to the rest of the euro area.
The only way to restore the flow of funds from the core to the periphery is to repair stressed balance sheets, including through bank resolution and recapitalization, and by making credible down payments on the fiscal and banking union. In order to achieve that, the next Italian government needs to be credible for its domestic policies and effective in designing a European solution encompassing the interests of all other countries. It is a tall order that probably requires a very experienced leader.
All scenarios are associated with instability
No matter how it will take shape and which nature it will have - political or, more likely, “institutional” - the government that emerges from the vote of 24-25 February would have a less defined political identity than a one-party government and would require long preliminary negotiations. It is reasonable to foresee that the coalition would absorb part of its personality by keeping the commitment to the European agenda. In fact, even after the painful compliance with European fiscal rules, Italians still look favorably to the European Union and the European Monetary Union. Confidence in the European institutions actually increased by 2% last year and is regularly higher than confidence in the national parliament and the national government.
The adherence to the European agenda is a significant indicator of the future policies given the extraordinary increment in surveillance and coordination required by the Treaty on Stability which will be applied starting next year. (As explained in “What Italy Can Expect after Monti”, Carlo Bastasin, November 26, 2012, Brookings Up Front Blog).
From a European point of view, the defeat of Berlusconi was generally regarded as highly important because it would stave off what is seen as one of the greatest threats to the euro and a real paradox of democracy in the euro system. Berlusconi has been fighting his campaign on the basis of a harsh critique of the European fiscal straitjacketing, or “German austerity” as he calls it. He has also been relentlessly and personally attacking German Chancellor Angela Merkel. A victory by Berlusconi and a departure from austerity would obviously be observed with fear and criticism by investors, and thereby push Italy closer to requesting an assistance program by the euro partners. In such an assistance program, the lion share would be provided by German tax payers. The paradox, therefore, is that due to Berlusconi’s campaign against Germany and Europe, the Germans would be called upon to be more sympathetic to Italy and show tangible solidarity with someone who has been bashing Berlin all the time. Not only would this be illogical in general, but all the more so if it happens at the height of the German electoral campaign ahead of the federal election on September 22, 2013. Inevitably Italy would become an electoral issue, and German voters would vote against a European policy of solidarity. Assistance to Berlusconi would be denied. Italy may then wind up on the verge of a default.
The election shows that any responsibility that Berlusconi may have in the new government will not be exclusive, substantially reduces the danger of a German-Italian showdown. Nevertheless the new government will be subject to scrutiny by the other partners in Brussels and by investors throughout the world. Skepticism by creditors - both public and private - could produce pressure on Italy’s financing of its public debt and request the new government to comply with a program of reforms different from the one that Bersani or Berlusconi prefer. If the challenge is not taken up, the government could wind up requesting an Outright Monetary Transactions (OMT) program sooner rather than later. However the required conditionality and terms set out in a future MoU in connection with an OMT request would put severe strains in the coalitions both of left and right. A European program of assistance would hardly be acceptable for the Partito Democratico and for the Popolo della Liberta’ that would find themselves again in the middle of a new electoral campaign. For all these reasons it is highly probable that in the next weeks all major parties will negotiate to agree on a new technical or institutional government. In fact, by doing so, they will stave off the political costs of managing a painful phase, just as they did with Mario Monti in November 2011.
In this “lowest common denominator” legislature, the way Italian legislative and executive powers will work depends also on the role that Grillo’s party assumes with its strong parliamentary representation. The “Movimento cinque stelle” is generally considered to be a source of political instability that could throw more sand in the wheels of the painstakingly laborious Italian legislative process. But this still needs to be seen. However, Grillo’s party could also represent an unprecedented innovation in European political culture with potentially profound consequences, even to the point of redefining democracy. The movement’s roughly 100 MPs, elected by a sentiment of profound skepticism against policymakers, will scrutinize all the political activity of the parliament and the government inside and out. They are likely to request full transparency on any legislative act. They will put enormous pressure on their colleagues, embracing a language that knows no respect for the usual parliamentarian doctrines of privacy and, on the contrary, is extremely advanced in using the internet as a platform to inform citizens. For all the grave problems that Grillo’s non dialectic language and tribunician attitude create for democracy, Italian electors may have invented a new stratagem to make parliamentary life more transparent in the age of the new media technology.