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Monti’s virtuous cycle

13 February 2012 By Hugo Dixon

Mario Monti’s ability to take a crisis and turn it into an opportunity may one day be taught as a case study in political economy. When Italy’s technocratic premier succeeded Silvio Berlusconi last November, the country’s 10-year bond yield was above the 7 percent level that had driven Greece, Ireland and Portugal to seek bailouts. Now it is 5.5 percent – still high but moving in the right direction.

Countries with high debt levels like Italy – its borrowing is 120 percent of GDP – are prone to self-fulfilling prophecies on both the upside and the downside. If investors think a government will go bust, borrowing costs rise which, in turn, makes bankruptcy more likely. But if markets think it is solvent, borrowing costs fall and that means it’s unlikely to fail.

In Italy, where I spent much of last week, there have been spirals within spirals. One has been via domestic politics. Monti has so much credibility that he has been able to reform the pension system, liberalise a raft of monopolistic industries and launch a high-profile crackdown on tax evasion. That has helped cut Italian bond yields, further boosting his credibility.

Another spiral has been via international politics. The prime minister’s credibility was an important factor in convincing the European Central Bank to let euro zone banks borrow 500 billion euros before Christmas. Italy was the biggest beneficiary. Its banks are no longer staring into the abyss, with the result that the credit crunch which threatened to suffocate Italian industry is going to be less severe. Moreover, some of the ECB money is finding its way into government bonds, lowering Rome’s borrowing costs.

Monti’s credibility has also helped persuade Germany’s Angela Merkel to ease up a bit on her austerity mantra. One consequence is that, if Italy misses its target of a balanced budget next year, it is unlikely to be forced to tighten fiscal policy again – something that would risk sucking Italy into a Greek-style austerity spiral. President Barack Obama even complimented Monti during an audience last week, saying he had restored faith in Italy and generated confidence in Europe.

The contrast with the end of the Berlusconi era is stark. The then prime minister had little credibility at home and so was unable to push through reforms. He was considered a naughty boy abroad and so was cut no slack. He was shunned by Obama, being left to hang around with the likes of Russia’s Vladimir Putin and Libya’s Muammar Gaddafi. And spiralling bond yields pushed the country and its banking system to the brink, while tipping the economy into its current recession.

But Monti cannot declare victory. Yields are still high. The economy is forecast by the International Monetary Fund to shrink 2.2 percent this year. And the debt hasn’t gone away. This makes the country vulnerable to shocks such as a blow-up in Greece.

While there’s little Monti can do about short-term growth, he can get yields down further with three more measures: labour reform; structural reforms in tax and spending; and privatisation. Such reforms won’t have an immediate impact on productivity. But they would further enhance credibility and so cut Italy’s borrowing costs, giving further rapid twists to the virtuous spiral.

Monti is well on the way to tackling the labour market, with measures to make it easier to hire and fire people. He should also find it surprisingly easy to push these through given that his trust rating with the electorate is at an extremely high 57 percent, according to the Italian pollsters SWG. Even the radical pension reform, which increased retirement ages and cut benefits, provoked only a three-hour strike.

The new government has been more circumspect about fiscal reform. Here what is required is to cut waste and recycle the savings into lower taxes on employment. Similarly, Monti hasn’t committed himself to privatisation. Given that the state has assets worth over 1 trillion euros, it should be possible to sell off large chunks in a multiyear programme to cut the country’s debt well below 100 percent of GDP.

But the most fundamental change Monti could help engineer is in Italy’s self-serving culture where rules are not observed and cheating is given a nod and a wink. Berlusconi made that worse by going soft on tax evasion (which is estimated to cost 120 billion euros or nearly 8 percent of GDP a year), by using parliament as a tool of his personal interests and through his long-running battles with the judiciary.

Monti, by contrast, has started to change the discourse of politics. He is sober, not flamboyant – and comes across as honest. His crackdown on tax cheats has also created a stir. But he has pledged to resign after next year’s general election, meaning he has precious little time to bring about cultural changes.

The good news is that the people are thoroughly fed up with the current crop of politicians, who have an extraordinarily low trust rating of 12 percent according to SWG. That means there is a chance that new politicians could come in to fill the vacuum. The bankrupt electoral system which allows party bosses rather than the electorate to pick the MPs may be reformed. But there’s no guarantee of a clean sweep. What’s more, it seems unlikely that Monti’s successor will be as good as him – and it would be hard for the prime minister to stand for election himself without going back on his word and so undermining what he stands for. Still, he’s made a remarkable start.


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