Italy's Election Raises Questions

Romano Prodi appears to have eked out a narrow victory. But does he have the support to spur economic reforms?

Italy's dead-heat national election on Apr. 9 -10 had Italians glued to their TV sets all through the night and biting their nails into the morning of Apr. 11, when a slim victory for the coalition of center-left leader Romano Prodi finally looked clear. Former European Union President Prodi, 66, defeated Prime Minister Silvio Berlusconi, 69, by a narrow margin in both the upper and lower houses of parliament, forcing the country's richest businessman out of office after presiding over five years of economic decline. But much to the dismay of many Italian business leaders, Prodi failed to win the strong mandate for change, which they hoped could spur vital reforms.

Prodi edged past Berlusconi in the race for control of the lower house of parliament with 49.8% of the vote for his Union coalition, a scant 0.1% better than Berlusconi's House of Liberties coalition, or a mere 25,000 votes. Italy's Interior Ministry declared Prodi winner of the election, but his tenuous advantage prompted Berlusconi supporters to immediately demand a recount. Italy's highest court will now have to rule on claims such as invalid ballots, which could drag on for weeks.

The election results did nothing to brighten the somber mood that persists across Europe's fourth largest economy. Berlusconi's broken promises of an economic miracle and his legacy of decline will hang over Prodi's new government, economists say, crimping his ability to take bold steps. "I'm extremely discouraged about the time we've lost," over the past five years, says Nerio Alessandri, founder and chief executive of Technogym, a $333 million maker of fitness equipment based in Gambettola. Making Italy Inc. competitive again should be top priority, argues Alessandri.


  But Prodi's urgent first task will be attacking Italy's spiraling budget deficit, which could hit 4.5% this year and its towering national debt, which has been rising steadily for two years and is headed for 107% of gross domestic product. That means curbing government spending and raising new taxes pronto. But those are hardly popularity-enhancing moves. The task is all the more difficult with Italy's economy forecast to grow at a feeble 1.2% in 2006.

Prodi will have to feed Italy the long-overdue medicine that the perpetually optimistic media magnate and former cruise-ship crooner Berlusconi never did. Rating agency Standard & Poor's warned this week that Italy must quickly take "concrete measures to deal with its fiscal crisis" and said inaction could result in a downgrade, which would bring the country's sovereign bonds below the AA- level that can be used as collateral by central banks.

That makes Italian bonds less palatable to investors, and it makes servicing Italy's debt more expensive. "The immediate pressure is on the fiscal side. Until measures are taken fiscal pressures limit your options," says Edward Teather, an economist at UBS in London.

"Priority No. 1 is bringing the budget deficit under control," agrees Tito Boeri, a professor of labor economics at Bocconi University in Milan. "A downgrade would be very serious."


  Prodi is not new to the job of tightening Italy's belt. As prime minister between 1996 and 1998, Prodi reeled in government spending and put the country on track to become a founding member of the euro zone in 2000 -- much to the astonishment of finance ministers in northern Europe. It was the center-left that did the fiscal adjustment to Italy's economy in the 1990s, notes Boeri. "Prodi can do it again," he says . "The hard things should be done in the first two years."

The question is, how much capital will Prodi have to spend on such belt-tightening moves just to stabilize government finances, before he can even begin to tackle economic reform? Given his razor-thin majority in the Senate, tough measures are likely to prompt political infighting. Far left coalition partners, including two communist parties, make up nearly 10% of Prodi's support base. And firebrand communist leader Fausto Bertinotti is once again an ally despite having torpedoed Prodi's 1998 government.

This time around, say political analysts, Prodi is likely to bring far-left leaders into his government, giving them key ministries such as labor to co-opt them into sharing responsibility for solving Italy's economic woes. "That is the lesson Prodi learned form his previous stint as prime minister," says Fabrizio Tassinari, a professor of international relations at the University of Copenhagen and policy analyst at the Center for European Policy Studies in Brussels. "That would give responsibility to the coalition's most unreliable forces -- it will be a key issue giving credibility to the government."

Berlusconi, who was brought down by the far-right Northern League party in 1994, did exactly that. When he won by a large majority in 2000, he included fractious Northern League leaders and put them in key posts. That helped him preside over the first postwar Italian government to survive a full five-year term.


  The key economic reform business leaders await from Prodi is his pledge to cut taxes on labor by 5%. Economists say the move will help reduce overall costs for business, chisel away at the country's huge underground economy and spur Italy's export competitiveness. Such a move, combined with a pickup in growth in Germany, Italy's largest trading partner, would help staunch Italy's decline.

"Part of Italy's problem is government overspending, but part of it is poor growth. If Germany enters a period of sustained growth, Italy with benefit," says Teather at UBS.

One of the biggest reform challenges facing Prodi will be injecting greater flexibility into Italy's rigid labor market. Like France, where massive protests reversed passage of a law that sought to encourage companies to higher younger workers by making their employment terms more flexible, Italy already has a large number of workers employed through temporary contracts.

Italy's labor market remains extremely rigid because the country lacks a comprehensive unemployment insurance system. Government payouts to laid-off workers are decided on a case-by-case basis and tend to only cover larger companies. That makes routine restructuring at the bulk of smaller companies -- which comprise 70% of the Italian economy -- nearly impossible. "It's a major obstacle to restructuring," notes labor expert Boeri.


  Prodi's platform also includes a plan to create a kind of "tenure track" for workers, which would help them clinch a job on a flexible contract that over time adds increasing protections for the worker. The idea is not to create a new labor contract for the disenfranchised, as France tried, but to adjust the existing contract in a way that would permit companies to hire workers on a flexible basis and compel them to grant an increasing amount of protection over time.

Economists also point to reforms that would not cost the government anything but would unleash fresh competitive energy in Italy's economy, such as liberalizing Italy's high-cost service sector including energy, transportation, communication, retail trade, and a variety of professions. The idea is to rid the system of guild-like rules that have their origins all the way back in the Middle-Ages.

Prodi clearly has some promising ideas. But if his coalition becomes wobbly, Italy's centrist parties may seek to form a kind of grand coalition in the center. The path to putting Italy's economy back on track is clear, but the drama has just begun.

Click here to read "In Italy: Small Changes, No Renaissance."

Click here to read "'Made in Italy' is Obsolete."

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