Europe’s Latest Wake-Up Call: Italian Elections

Europe, which has been enjoying a recent respite from financial chaos, is about to get a rude awakening: Italian elections. Voters will go to the polls this Sunday through Monday, and the winner will soon upset the Eurocrat and financial calm that has surrounded Italy since Mario Monti’s caretaker government took office in November 2011. In the months following this weekend’s election results, financial markets will increasingly expect progress on reform of Europe’s third-largest economy. But Rome will be unwilling to deliver.

That’s because the almost certain winner, a centre-left coalition led by the Democratic Party is resistant to the kinds of reform that Italy badly needs. There is some hope for change, however.

Although Italy’s centre-left coalition is likely to win a majority in the House of Deputies (Italy’s lower parliamentary chamber), a clean victory in the Senate (the upper chamber) is much less probable. As a result, the centre-left group will probably coalesce with the centrist group backing former technocrat Prime Minister Monti. Despite his technocrat government’s lackluster record, Monti has at least attempted liberalizing reforms and budget consolidation. And he has set forth a new agenda pushing for more. In contrast, the Democratic Party wants to go in the opposite direction: adding more regulations to an already broken labor market and easing the drive for austerity begun under the Monti government. But a centre-left coalition that includes pro-Monti centrist parties will have to make concessions for liberal reforms and budget consolidation, or risk governmental collapse.

There’s also the specter of the populist Five Star Movement threatening to compound parliamentary logjam. Although it seems highly unlikely that it will be part of any governing coalition, current polls place the movement at receiving roughly 15 percent of the general election vote. That translates into a smaller percentage of parliamentary seats because of a special “majority bonus” going to the proportional winner in this weekend’s elections, but the movement is loud and has an enthusiastic following. Unfortunately, its economic illiteracy is rampant—with radical propositions like banning stock options.

Notwithstanding the composition of Italy’s new government, any newcomer faces a challenging list of necessary reforms.

  1. Labor reform: It is illegal for employers to dismiss workers for poor performance, difficult to dismiss them for willful negligence, and downright expensive to lay them off in trying economic times. As I’ve written in The Wall Street Journal, these restrictions have a crushing effect on business and entrepreneurism. They are also incredibly difficult to change. One especially relevant reason for this is that the Democratic Party heavily relies on union support and will not bite the hand that feeds. Party Secretary Pierluigi Bersani, taking the same stance as Italy’s largest and furthest to-the-left labor union, continues to deny that these laws have any effect on business or unemployment. Reform under a centre-left government is a tall proposition. Monti made an attempt to address the dire state of Italian labor last spring, but ended up caving to powerful political and union pressure. Despite grand fanfare from his government and the media, his so-called reforms made Italy’s labor markets yet more inflexible.
  2. Reducing Italy’s sky-high tax burden: Italy has the highest implicit tax rate on labor in Europe, the fourth-highest tax wedge (the difference between before-tax and after-tax wages) in the Euro Area, and one of the highest consumption tax rates (VAT) around. Fortunately, the Democratic Party has expressed a willingness to reduce the burden of taxation upon labor. Unfortunately, it also favors making the property tax instituted under Monti more progressive.
  3. A slow and inefficient court system: The average legal case takes nearly 3.5 years to resolve in the Italian court system. Labor disputes, but not dismissals, take even longer to adjudicate at four years. New reforms under Monti attempt to speed up legal proceedings for dismissals, shortening the court proceedings from almost two years to one. But there are two problems with the changes: 1) one-year for adjudication of a dismissal case is still woefully behind the rest of Europe, and 2) Monti’s reforms deal entirely in mandates and procedural changes that do nothing to lessen the inflow of cases overloading the judicial system. If there were not so many rules regarding dismissal, there would be fewer cases. This is the best fix, but it’s also the most difficult politically.

There are also the problems of Italy’s heavily cartelized service sector and its one-size-fits-all national collective bargaining system that ignores regional differences in costs of living, which I discuss in the EU Observer. In the same article, I explain why Italy’s post-WWII political history has been one of consistent resistance to change and why deviation from this is so difficult.

Change is anathema to Italian politics, as a broken political culture left over from the Cold War continues to frame debate and hold down the economy.

Before the early 1990s, the Christian Democratic Party had been in government for nearly five decades.

For years, it gave huge concessions to special interests, especially unions and professional guilds, to keep the peace in parliament and to keep Italy’s sizeable Communist Party from exploiting partisan disagreement to gain support.

These groups said “jump” and politicians asked “how high?”

The situation is not much different today.

As markets anxiously await the election results, they should not be fooled by overoptimistic rhetoric from the contenders. Reform, under any government, is not likely to occur without the impetus of strong and persistent financial pressure. Despite the European Central Bank (ECB) having been the most generous to Italian sovereign bonds under purchases through its Securities Market Program ending last September, Italy is not likely to continue getting a free a lunch from the ECB. The bank’s new bond-buying program, Outright Monetary Transactions (OMT), is conditional upon beneficiaries carrying out reforms. Non-transitory rising bond yields will force change, as they did in November 2011 with the ousting of do-nothing former Prime Minister Silvio Berlusconi. Change stagnated afterwards because markets took Monti at his word for reform and then relaxed, instead of holding him to his promises for reform throughout his tenure. The other scenario is that financial pressure pushes Italy into applying to the OMT program, which then forces reform, though most likely at a slower pace.

The incoming government, sooner or later, will have to face up to reforming a stagnant economy. How long and painful the road to reform will be rests on how powerful is the new government’s denialism towards the reality of inevitable structural change.