Italy's Impossible Choices

In boardrooms across Italy, top business leaders are glum. As the upcoming national elections on Apr. 9 and Apr. 10 approach, the chances of any party supporting vigorous and urgently needed economic reform look scant. That may well condemn Italy to further economic stagnation, rising debt, and sliding industrial competitiveness -- as well as to shock therapy some time in the future.

"What Italy needs is a kamikaze government that rams through radical economic reform for two years and then self-destructs," says one of Italy's top industrialists, who fears political deadlock is the likely scenario no matter who wins.


  The sense of delusion among top executives is deep. Five years ago, center-right Prime Minister Silvio Berlusconi, a media mogul and the richest man in the country, with a net worth of some $12 billion, promised business leaders a major economic overhaul -- including lower taxes, an Italian miracle of sorts. But he failed to deliver.

Center-left challenger Romano Prodi, a former European Commission President, is promising to push through needed reforms such as cutting taxes on labor and liberalizing key markets, including professional services.

But many who oppose Berlusconi also fear that a fractious left-wing coalition, including extremist parties, will thwart and eventually topple Prodi, a Roman Catholic centrist without a party base, before he can galvanize change. Fausto Bertinotti, a hard-line communist, torpedoed Prodi's two-year-old government in 1998.


  In the final calamitous days of campaigning, which were low on substance and high on theatrics (such as Berlusconi storming off the stage of a TV interview after being described as "the politician with the biggest conflict of interest in Western history,") it appears that Prodi, 69, may win by a 3% to 6% margin. Whether Prodi or Berlusconi forms the next government, though, the economic challenge is daunting.

"Italy will not be able to muddle through" this time, says Riccardo Faini, a former Treasury official and professor of economics at the University of Rome. "What matters is whether Italy has the economic strength and political ability to face the shock."

Italy Inc. has famously defied decades of chaotic Italian post-war politics and managed to prosper. But globalization is fast eroding that ability. Italy's decline in competitiveness, which started in the early 1990s, is now accelerating. Small and midsize companies, the country's economic backbone, lack the size, capital, and technological edge to compete in high-value goods.


  Many still produce simple products such as shoes, paper goods, and wood products, which are being undercut by Chinese and Indian rivals that can produce at a fraction the cost. At the same time, many sectors of the economy, especially services, remain tightly regulated and effectively closed to real competition, keeping prices high and limiting the chance for Italian entrepreneurs to diversify into new businesses. Energy prices in Italy are the highest in Europe and run 30% to 40% above the EU average.

The clearest sign of a problem is Italy's increasingly uncompetitive exports. The country's share of global trade declined from 4.6% in 1995 to 2.7% last year.

As smaller Italian companies were forced out of business, Italy lost some 10,000 jobs in 2005. GDP growth, which has been hovering around 1%, stalled completely in 2005. And the country's staggering debt, running at 106%, is on the rise again.


  "All the economics have gotten worse in the past five years," says James Walston, professor of political science at the American University in Rome. "The process is going to be very painful."

The antidote to Italy's economic malaise is clear, economists say. Top priority is fiscal discipline to rein in the budget deficit and debt. Lowering taxes on labor is also vital to bringing labor costs down and promoting employment. For every $100 paid to a worker in Italy, employers must pay another $90 in social charges, making the business tax burden on labor one of the highest in Western countries.

"Today there is a disproportionate gulf between the salary that ends in the worker's pocket and the total labor charges paid by a company," says Vittorio Merloni, chairman of Indesit, the Italian maker of white goods.


  Prodi's center-left coalition, called The Union, has proposed lowering this 90% tax wedge by some 5%, while the Italian Industry Assn. is calling for a 10-point reduction over five years.

Some of the benefits to employers of a lower tax on labor would be offset, however, by Prodi's aim to increase employment protection and welfare benefits. "He will go some way to address the problems, but he will not be radical," says Walston.

What's the best-case scenario? Prodi wins by a solid margin and controls both houses of parliament, granting him a window of opportunity for a bolder reform plan -- not unlike the kamikaze approach some industrialists dream of. If he wins by a solid margin, Prodi should prepare Italians to stomach a very uncomfortable 12 months to 18 months, says Walston.


  Says Walton: "He should also promise to share the burden equally between business and labor, and he should privatize and liberalize, introduce flexible working hours, and underpin labor market flexibility with welfare safeguards."

Unlike Germany or other northern European countries, Italy has no comprehensive welfare system. So those who lose their jobs without a special government promise of aid, receive no state support. That means that fixing labor market rigidities in Italy would involve overhauling government policies at the same time.

Anticipating that a Prodi-led government will be unstable, industry leaders are already trying to look beyond the immediate election for a way forward. One might be a political implosion on both the left and right that gives rise to new political parties and new, younger leaders. That alone might enhance the chances of a kind of grand coalition of new generation politicians from the center-left and center-right -- not unlike German Chancellor Angela Merkel's grand coalition.


  "We have two leaders who are 70 years old who have already run against each other 10 years ago. Both have had a chance at leading -- and the country's problems have only gotten worse," frets the chief executive of one of Italy's largest companies, who preferred to remain anonymous prior to the election. "We need someone different to look forward."

If the election on Apr. 9 and 10 does not produce long-overdue economic reform, stagnation may well end up being the catalyst for an even bigger political overhaul down the line.

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