Renzi will not revive Italy with reforms alone

Matteo Renzi is close to achieving his great ambition. Now what?

Italy’s new prime minister will have the most difficult job in Europe. Once confirmed, he will preside over a country with three fundamental economic problems: it has very large debt; it has no growth; and it is a member of a poorly functioning monetary union.

This situation is economically untenable. Unless Italy returns to growth, its debt will become ever more crippling, ultimately making its position in the eurozone impossible. The premier’s job may be difficult, but it can be stated simply: change one or more of those three variables – without leaving a mess behind.

Naturally, there are different views about what needs to be done. There seems to be some agreement that the outgoing administration did not do enough. I never ceased to be amazed by Enrico Letta’s phlegmatic attitude to reform. It is a year now since the Italian elections, and 10 months since Mr Letta took office. In that time, precious little has happened.

Mr Renzi said many times that the Letta administration was not working properly. The question is whether Mr Renzi has a sufficiently clear understanding of what needs to be done, and whether he has a big enough parliamentary majority to support him through the swamp of economic reform policies. On the former, I am moderately optimistic. On the latter, I am not. The standard answer about what Italy needs to do is some combination of economic reforms and fiscal consolidation.

This is not completely wrong. In Italy, the case for structural reforms is overwhelming, but I doubt it would be sufficient. To see this, recall the sheer scale of Italy’s economic underperformance. According to my calculations Italy’s gross domestic product is now 15 per cent below the trend the economy was on during the 1990s. It is not the financial crisis that did the damage in Italy. It is the euro itself.

If you lose 15 per cent of something, you have to grow by about 18 per cent to get back to where you started. It is a bit like catching a running train. This number is a rough measure of the scale of Mr Renzi’s task.

I do not mean that he should raise GDP by that amount in the next four years. This is impossible. But he could get the country back on to a trajectory that will eventually close the gap – or most of it. Still, even this it is a tall order. It is a bigger adjustment than the one that Germany has gone through or the one that France is just now beginning.

How much can structural reform achieve? An optimist would point to studies such as those by Lusine Lusinyan and Dirk Muir of the International Monetary Fund. Imagine a parallel universe in which Italy implements a wide range of the structural and labour market reforms right this minute. According to the authors, this would eventually increase GDP by 13 per cent over what it would otherwise have been. Interestingly, and contrary to popular perception, labour market reforms matter less than product market measures such as services liberalisation. If you add in fiscal reforms, the impact could be as high as 20 per cent. Job done.

I doubt those numbers are achievable. For a start, reforms never get implemented in totality – certainly not by an Italian coalition government. Even in Germany 10 years ago the reforms were not implemented in the way they were drawn up.

Furthermore, long-term forecasts are always speculative. We do not know that the economy will behave in the same way as in the past, now that interest rates are close to zero and the banking sector is dysfunctional. Longstanding correlations between economic variables may begin to break down.

Reforms, necessary as they may be, cannot do the heavy lifting all on their own. To keep Italy in the eurozone, Mr Renzi will also need help from the European Central Bank. And that means he needs to shift the macroeconomic debate inside the EU.

Four things must happen; not all of them are under Mr Renzi’s control. First, eurozone inflation must be prevented from persistently undershooting the inflation target, as it has been recently. Second, Italy needs lower market interest rates, which would require further unconventional policy measures. Third, shaky banks must be restructured and crumbling ones closed, and a “bad bank” set up to hold the debris. Fourth, massive current surpluses in Germany and the Netherlands will have to fall. These surpluses are making it extremely difficult and painful for the eurozone periphery to adjust. Mr Renzi should channel his rebellious spirit and make this case to his northern neighbours.

For the Italian economy to return to a sustainable path in the eurozone, Mr Renzi will need to sort out the banks and stand up to his European partners. His predecessors may have left it too late. The task may now be simply impossible. To succeed, Mr Renzi will need skill, clarity, determination and, most of all, a lot of luck.

Wolfgang Münchau


FT