Prime Minister Silvio Berlusconi's days look numbered, following the loss of his governing majority in the Italian parliament. He has pledged to the Italian president to resign following the parliamentary passage of the 2012 budget expected later this month. This development is generally very good news. As negotiations in Athens head toward installation of a new Greek unity/technocratic government, the transition in the final euro area periphery nation to new majority political leadership in favor of International Monetary Fund (IMF)-inspired structural economic reforms and fiscal consolidation1 is just about complete. These developments should provide greater clarity and stability in the euro area periphery.
In the short run, however, the collapse of two peripheral governments will further add to the political uncertainty in Europe. For example, as the continuing turmoil in the sovereign debt markets indicates, Berlusconi's departure is a necessary but not sufficient requirement to restore Italy's credibility in the eyes of most investors. Several important political caveats still exist.
First, Berlusconi has not resigned yet, so it is not clear what his promise to the Italian president is ultimately worth. Before the 2012 budget is voted through the Lower House and Senate, he may try to re-establish his governing majority in parliament. With his formidable political and financial powers, he could offer incentives and threats to lure some of rebels in his coalition who abstained from voting on Tuesday into supporting him again. Thus he could conceivably hold on to power, even though in principle the Italian president retains the power to dismiss him and call for new elections. It seems likely that Berlusconi, embattled by charges of personal corruption and misbehavior, would try to obtain some sort of future immunity from judicial procedures against him as part of a negotiated departure. This seems one aspect of moral hazard that Italian politicians will have to consider.
Second, no one knows what kind of government will replace Berlusconi. The Italian president has in recent weeks been sounding out the leaders of other parties about establishing a broader based government. The best outcome would be a widely supported pro-reform technocratic regime, tasked with restoring Italy's growth prospects. There is a tradition for this type of "crisis government" in Italy, including the governments of former Bank of Italy governor Carlo Azeglio Ciampi in 1993-94 and (another senior Bank of Italy staffer) Lamberto Dini in 1995-96. Further back in time, the government of Prime Minister Alcide De Gasperi ruled during the Italian post-war monetary stabilization of 1947.2
In this reform-friendly scenario, the supervisory role of the IMF announced in the recent G-20 communiqué3 would probably be unofficially expanded to include a more prescriptive role for required economic reforms. A more prominent role for the IMF as a "partner-in-reform" for a new Italian government should also strengthen the market credibility of such a government, given the IMF's unique experience and respect in financial markets.
But there is also a risk that a post-Berlusconi government will only have marginally broader parliamentary support, in which case it would remain politically beholden to the Northern League. Unsurprisingly, such a coalition is the preferred outcome of Berlusconi's closest political allies, including the Northern League's longtime leader, Umberto Bossi. In this scenario, the probable reform implementation progress in Italy would be small. Like every other parliamentary grouping, the Northern League and other parts of Berlusconi's erstwhile coalition government have been beholden to their own special interest groups. As the same is obviously true for the Italian center-left, only a new government with broad-based bipartisan support looks likely to have the political strength to overcome reform opposition from entrenched beneficiaries of the status quo. Again, the role of the Italian president, Giorgio Napolitano, will be critical. He will have to exercise significant input on the decision about forming a new government or calling elections if no suitable coalition can be pieced together.
President Napolitano has generally been evenhanded and apolitical in office since 2006, but these are not normal times for Italy. He comes from the Italian left, so his personal inclination would probably be in favor of a broad national unity/technocratic government, rather than a marginal expansion of the existing center-right coalition. A "Berlusconi plus" coalition (which would do little to improve political certainty or stability) would not likely be acceptable to the other European countries, the European Central Bank (ECB) or even the G-20. Italy's outside partners will want a firmer commitment to implement reforms than any that can be obtained by a small expansion of the current ruling coalition. These political constraints are surely understood by President Napolitano.
In light of the rising stress in Italian sovereign debt markets, it finally seems least likely that President Napolitano will call for new elections now. Elections would prolong the acute political uncertainty in Italy and also play into the hands of Berlusconi, who continues to control large parts of the Italian media. New elections now would enable him to heavily influence the election outcome and undercut prospects for reform.
Nor should one expect any change in the ECB's current strategy of "conditional intervention" through its Securities Market Program of sovereign bond purchases. The ECB Governing Council will want to maintain the acute market pressure on Italy's political leaders and insist on concrete delivery of reforms before intervening to lower Italian spreads. Indeed, it would be rational for the ECB to increase the economic pressure on Italian politicians—and to make sure that Berlusconi goes and is replaced by a technocratic team of rulers—by letting interest rates on Italian debt spike.
The list of economic reforms to be implemented is long and well-known. They have been spelled out by Mario Draghi, the ECB president and former head of the Bank of Italy, and his predecessor at the ECB, Jean-Claude Trichet, in their not-so-secret letter to Berlusconi last August. Fortunately, Italy will not need to implement a great deal more of austerity, but instead can focus on raising its low potential growth rate through supply-side structural reforms.
Most important, Italy's leaders must convince the next generation that it has a promising future by dismantling the web of regulations in labor and product markets favoring incumbent older male insiders at the expense of the young, women, and immigrants.
Another crucial constituency to be won over is Italy's notoriously wealthy household savers, who must be convinced to keep their riches inside Italy and in Italy's banks in particular. In light of the "nuclear threat" delivered by Chancellor Angela Merkel and President Nicolas Sarkozy that Greece would be ousted from the euro area if it did not comply with the IMF program, Italy's households require new assurances of the security and reliability of the Italian financial system. In extremis, a potential threat of expulsion from the euro area—which of course for Italy is virtually unthinkable—could nonetheless lead to bank runs, as Italians would rush to turn their perceived vulnerable Italian euros into a safer "German euro" by putting them into a German rather than Italian bank. Were the credibility crisis of Italy's current government to reach the Italian banking system in this way, the integrity of the entire euro area would be compromised.
As of September 30th, however, there was no sign of a flight of Italian bank deposits. Data after the August 2011 widening of Italian government spreads actually show that deposits are up marginally from both the month before (about €5 billion) and the same month in 2010 (about €10 billion).
The potential savings in the Italian household sector are so large that they arguably account for the most important "hidden strength" of the Italian economy. Indeed these savings set Italy apart from the rest of the euro area periphery. Italy may have about €1.9 trillion in government debt and low growth prospects, but Italian households at the end of 2010 had about €1 trillion in current account deposits in Italian banks and post offices alone and €3.7 trillion in total financial assets.4 Total Italian household financial liabilities accounted for just €923 billion. Meanwhile, total real assets of Italian households—mostly accounted for by dwellings which are relatively stable in price—were almost €6 trillion.5 If Italians trust their government enough to prevent it from financially collapsing, there should be ample domestic wealth to do so.
Rome has abundant scope to tap parts of its citizens' wealth via measures of "soft financial repression"6 —such as inducements to invest in sovereign debt—if Italians are convinced that it is in their interest to help avoid a financial collapse. Considering that most affluent Italians are ageing and will be relying increasingly on governmental health and care services, it seems probable that a credible and reform-minded new Italian leader could convince them to accept short-term financial sacrifices in their own longer-term interest.
It is certainly hard to imagine that there would ultimately be any other place in the world that Italians would want to retire in than Italy. That is the case Berlusconi's successor will have to make.
1. Ireland and Portugal already have newly elected majority governments committed to implementing their IMF programs, and Spain's pro-reform opposition Partido Popular (PP) is widely expected to win upcoming Spanish elections on November 20th.
2. See my colleague Juan Carlos Martinez Oliva's excellent paper on the 1947 example of cooperation between politicians and technocrats in Italy.
3. In Cannes, the G-20 leaders "welcome[d] Italy's decision to invite the IMF to carry out a public verification of its policy implementation on a quarterly basis ."