Can Berlusconi Revive Italy's Economy?

He's back in the saddle and promising tax cuts and state asset sales, but Italy's faltering economy may prove to be a bewildering challenge

Italy's general election brought a victory for Silvio Berlusconi, who is now preparing to return as Prime Minister 20 months after his last election defeat. This time, Berlusconi has a comfortable majority in both houses of Parliament, which will make it easier for him to pass controversial reforms. Whether he will manage to revive Italy's faltering economy, however, remains in doubt.

Berlusconi announced that he plans first to address the garbage problem in Naples and the troubled airliner Alitalia (AZPIA.MI). His priorities also include the abolition of property taxes, the introduction of a baby bonus, and a raise in pension levels that are currently under €1,000 ($1,580). In the runup to the election, Berlusconi promised tax cuts that, together with increased infrastructure spending, could boost Italy's faltering economy.

Shares of companies likely to benefit from more public spending on infrastructure rose after the election. Yet Italy's stock market didn't outperform other European markets, which indicates that Berlusconi failed to spark a turnaround in sentiment overall. Indeed, the need to finance a very high debt burden is one of the factors that has held back public spending in recent years. Adding to the mounting debt level could put Berlusconi on a collision course not only with the European Commission but also with a market wary of accumulating budget problems over the coming years.

Deficit Demands

In the wake of the last Berlusconi government, the 2006 ratio of government deficit to gross domestic product reached a staggering 4.4%. The data were partly affected by special factors. Yet it seems clear the deficit increase was also due to the unwinding of the more prudent budget policy under previous Prime Minister Romano Prodi. In 2007 efforts to curb tax evasion brought the deficit-GDP ratio back below the 3% limit, and the EU announced this week that the excessive deficit is likely to dissipate. But with growth slowing sharply and the government preparing for more tax cuts, the deficit-GDP ratio could soon rise above 3% again.

The designated Economy Minister, Giulio Tremonti, has already issued warnings that the budget won't look good, but he blamed it mainly on the international financial crisis. He indicated he plans to keep the budget under control primarily with the help of sales of state assets. However, the dragged-out privatization of Alitalia demonstrates that a sale of assets is not always easy. Berlusconi argued against a sale to a foreign investor, which is in line with Tremonti's attack against globalization. But there is no serious domestic offer in sight and liquidity runs out in June, so the government may have a difficult task.

In any case, asset sales can only be a temporary measure to keep the deficit down, as structural reforms are what Italy needs to bring public finances back on track and boost overall growth. Italian growth already slowed to just 1.5% last year, from 1.8% in 2006. Detailed data for the fourth quarter of 2007 still have not been released, but the full-year estimate suggests a contraction—or a stagnation at best. The International Monetary Fund forecasts Italian GDP growth of just 0.3% this year, and while officials say that may be too pessimistic, they agree the economic outlook is not rosy.

Housing Woes

The slowdown in recent years has partly reflected the fading impact of declining interest rates in the runup to European monetary union. Italy experienced a housing boom on the back of low interest rates after the start of EMU, and house-price inflation reached rates higher than 20% in 2003 before slowing. House-price inflation turned negative last year, which meant consumers were faced not only with slowing growth but a decline in the value of their real estate assets. The situation has improved slightly, but annual growth rates remain quite low. On top of this, the Italian stock market has declined sharply, and it continues to underperform vis-à-vis other euro zone countries.

With consumers facing a deterioration of property values, alongside falling domestic equity values, it was only a matter of time before consumption would be affected. This is especially true as Italian inflation has risen in line with the rest of the euro zone. March inflation, as measured by the Harmonized Index of Consumer Prices used by the European Central Bank (ECB), accelerated to 3.6% year-over-year from 3.1% in February, with national inflation reaching 3.3% year-over-year, after being 2.9% in the previous month.

The breakdown showed prices for food and beverages up 5.5% year-over-year. And, transport prices, which include gasoline, were up 5.8%. This indicates that, as elsewhere, food and energy prices are the main drivers for higher inflation. There is little consumers can do to reduce consumption of these two vital items in the short run, which means the sharp increase this year will eat into real disposable income and undermine consumption.

Export Disappointments

High inflation in previous years has undermined the competitiveness of Italian goods, and producers are facing increased competition on the global market—as well as a strong euro. Disappointing trade data show the Italian economy cannot rely on exports to generate growth. Government infrastructure programs may help boost construction and overall industrial production in the short run. But if these are credit financed, it can only be of short-term benefit, and more structural changes will be necessary to bring the Italian economy back on track.

The productivity growth ranking from the Organization for Economic Cooperation & Development places Italy at the bottom of the list. Italian companies are often small and reliant on manual labor, which means investment in research and development is lagging, and companies are unable to combat cheap competition from Asia—for example, in the textile industry. Indeed, it is not surprising that Tremonti is damning the effects of globalization. However, even Berlusconi won't be able to fully shield the Italian economy from the new competition and boost growth at the same time. Ultimately the industrial sector needs to shape up to survive.

For the government, a key issue will be the urgently needed reform of the pension system. Demographic changes mean the government is facing an ever-higher bill to finance the current system. However, the notorious instability of the Italian political machine has in the past meant that governments were not strong enough to pass painful reforms. In this respect, Berlusconi clearly is in a better position than Prodi.

There was no reform of the electoral system ahead of this election, as the President would have preferred. But it seems Italian voters were themselves disillusioned with the multiparty system and longing for clear and stable majorities. The splinter parties were the main losers in this election, and this is the first time the Communist Party won't enter Parliament. Berlusconi's coalition still has three parties and a small southern league. But he has a stable majority in both houses of Parliament, which means the chance for reform could finally be there.

Whether Berlusconi will want to tackle the roots of Italy's problems remains to be seen, however. What he almost certainly will do is go on a collision course with the European Commission over Italy's budget and with the ECB over interest rates. Berlusconi was quick to announce that the ECB needs a broader mandate and an increased focus on growth. This means French President Nicolas Sarkozy will finally have an ally in his attacks on the ECB. The political pressure on the central bank will probably increase, with Germany the last of the big three euro zone countries likely to defend the ECB's independence and inflation focus.

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