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A New Government Brightens Prospects for Reform in Italy



Italy's new prime minister, Matteo Renzi, picked a fortuitous moment to seize power by ousting Enrico Letta through an internal party putsch. Italy finally returned to growth in the fourth quarter of 2013 and Moody's raised Italy's credit outlook from negative to stable. But why now and what does his ascent mean for Italy and the euro area?

First, Renzi seems to have wanted to avoid the political price for the Letta government's poor performance on political and economic reforms. As leader of the biggest party in Letta's coalition, it is Renzi who will eventually have to face Italian voters. He can now reap the political benefits of an Italian economy that seems to have turned the corner.

Second, Renzi seems to have calculated that he can win backing from the small centrist parties for his structural reform agenda, which includes electoral, constitutional, labor market, public administration, and tax reforms. For example, former Prime Minister Silvio Berlusconi's old party—New Center Right led by Angelino Alfano—will likely be desperate to have a platform of accomplishments to run on and thus will probably join Renzi's coalition to accomplish this goal. Renzi, a former mayor of Florence who is untested at the national level, is nonetheless a skilled campaigner. Because he is only 39 years old, he has a better chance to confront his aging populist opponents in Berlusconi and Beppe Grillo, the former comedian who heads the Five Star Movement, if he runs on a record of reforms implemented. If Renzi fails, it is unclear where the country turns next.

The initial response to Renzi's ascent from financial markets has been positive. Italian 10-year rates fell to an 8-year low. Italians may well feel that a new generation cannot do worse than the outgoing generation. (Letta was a technocratic invention of Italian president Giorgio Napolitano without his own political power base.)

Italy still faces chronic low growth, a fiscal straitjacket from its high debt, and a potentially ominous European Central Bank (ECB) review of its banking sector. But in putting domestic structural reforms at the top of his agenda for the first 100 days, Renzi seems determined to make a difference. He appears inclined, correctly, to let the ECB deal with monetary policy and the banking sector review without comments from the Italian government. But of course he must be ready for adverse stress test results, due in late 2014. If that happens, the stabilization of Italy's fiscal situation and credit ratings should make it easier for the government to establish a national "bad bank" to speed up the restructuring of the Italian banking sector.

It would be futile for Renzi to pick a political battle in Brussels against the obvious imperfections of the euro area institutional structure and the fiscal constraints imposed on Rome in the last few years. Nor could he realistically take on the ECB's acceptance of today's ultralow inflation and high external surpluses of Germany, the Netherlands, and other core euro area economies. He might be young and reformist, but the words of a new and still unaccomplished Italian prime minister would not carry much weight outside Italy. Renzi is also right to ignore the Keynesian commentariat's demand that structural reforms in Italy first be purchased with an enabling fiscal stimulus blessed by Brussels. He rejects the nonsense that a stimulus bribe is required for a structural reform to work. The structural reforms necessary for Italy are only implemented when times are bad and there are no alternatives.

It is also possible that once structural reforms are under way, Italy may overshoot its fiscal target in 2014. Under the new flexible rules of the Stability and Growth Pact (SGP) for fiscal discipline, that improvement would make it far easier for Brussels to support Italy's fiscal stance.

The advice to Renzi must therefore be to go all out for reform in Italy and ask Brussels for fiscal forgiveness later.

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