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Italy’s dreadful Plan Bs

13 October 2014 By Hugo Dixon

Matteo Renzi’s Plan A is to push through domestic reforms, hope the European Central Bank manages to get inflation ticking up, and keep his fingers crossed the Italian economy stops shrinking. But if this fails, a mega wealth tax, debt restructuring and/or exit from the euro beckons.

There is no Plan B that wouldn’t tip both Italy, where I spent part of last week, and its neighbours into a severe crisis. That makes it all the more important that Plan A works.

Renzi has been doing a reasonable job since he took over as prime minister in February. He has boundless energy and is not afraid of fighting battles. The latest has been to reform the labour market – something that involved clashing with members of his own centre-left Democratic Party as well as its trade union backers. Last week, he had to call a vote of confidence to push the change through the Senate.

Important reforms of civil justice, the electoral system and the constitution have also started. All this is necessary to make Italy governable as well as a country in which business wants to invest.

The snag is that the prime minister is better at announcing reforms than delivering them. This is partly a function of Italy’s stifling bureaucracy which, to be fair, he is trying to kick into action. But it is also because of his own failings.

Renzi, who is only 39, has surrounded himself mainly with other inexperienced politicians. Meanwhile, all key decisions have to go via him. Although a strong central drive may be needed to combat vested interests, this inevitably leads to bottlenecks. One senior official says the only way to get through to the prime minister is to send him a text message, as requests to his office get bogged down.

Renzi’s next test will be the 2015 budget, which is due to be presented later this week. If Italy presents too lax a budget, the European Commission may reject it. That, in turn, may set off a negative dynamic where both Rome and Brussels dig their heels in.

Italy understandably doesn’t want to tighten the purse-strings too much as this would further crush the economy which has dipped back into recession. But given that Rome’s debt load is expected to hit 137 percent of GDP at the end of this year by the International Monetary Fund, the government needs to do everything to maintain credibility with both its European Union partners and the markets.

There are two obvious ways of squaring the budget circle. One is to fast-track privatisation, which would bring down the debt. The other is to crack down on wasteful public spending, which would cut the deficit. The snag is that Renzi seems to be going slow on privatisation and it is not clear whether he will accept the conclusions of the government’s spending review.

If this week’s budget doesn’t impress, it is most unlikely that there will be any short-term loss of market confidence in Italy. But Renzi would then have no reserve of goodwill if the Italian economy continues to shrink next year and inflation doesn’t pick up. In such a scenario, the debt/GDP ratio would go over 140 percent and keep rising. The view that its borrowings are unsustainable might then become widespread. The problem is that there would be no easy way to make them sustainable if confidence vanished.

One option would be for a one-off wealth tax. In theory, it ought to be possible to extract several hundred billion euros from the Italian people given their huge wealth. The snag is that the lion’s share of their assets is in property. People who didn’t have ready cash could hardly offer to pay such a tax with a spare bathroom.

There might be ways round this problem – say by getting banks to offer mortgages to homeowners, the proceeds of which could be used to discharge tax liabilities. But the prospect is not palatable.

A second option – restructuring Italy’s debt, say to bring it to below 100 percent of GDP – is even less appealing. Given that its borrowings are over 2 trillion euros, more than six times the size of Greece’s, a default would cause a financial earthquake that would be hard to contain.

There would be contagion to other EU countries, including perhaps France. Banks in Italy and elsewhere would have to be shored up, given their large holdings of Italian bonds.

The ECB would no doubt throw its protective mantle over the euro zone, by buying government bonds and lending to banks. But the dynamics of such a default could easily lead to Italy leaving the single currency and, indeed, the total breakup of the euro – which would cause massive economic and political dislocation.

It is therefore important that Italy never needs a Plan B.

Renzi himself can only do so much. The most important card – quantitative easing by the ECB to push euro zone inflation up – is not in his hands. Nor can he direct Angela Merkel to step up German investment, which would help boost the euro zone’s growth rate a bit.

That said, the way Renzi plays his own hand will affect the way the ECB and the rest of the EU play their cards. The more he can show he is capable of delivering reform at home, the more his partners will be willing to help him.


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