Prime Minister Renzi's Italian Dilemma

Its GDP is at its 2010 level—almost 10 percent below its 2007 peak—and per capita GDP has not grown since 1998. Despite not having suffered a housing bubble, its debt-to-GDP ratio is above 130 percent. Inflation is at zero, and inflation swaps predict average inflation over the next 10 years will not be much higher than 1 percent. Its birth rate is amongst the lowest in the developed world, and population growth has stagnated. This country could be Japan. But it is Italy, where the concept of Japanization, so fashionable these days among euro area observers, applies with special force.

The parallels with Japan also extend to the political realm. Similar to the recent rise to power of Prime Minister Matteo Renzi in Italy, the emergence of Junichiro Koizumi in the Japanese political scene in 2001 was hailed as a breath of fresh air that could eventually transform Japan's economy, politics, and society. Koizumi was charismatic, eccentric, attractive, young (at least by Japanese standards) and arrived as Japan entered its second lost decade.

Koizumi promised "reforms without sacred cows" and seemed to be a powerful alternative to the conformity that had seized Japanese society. After several failed attempts to reach power, always blocked by party barons, a change in electoral procedures that gave voice to grass roots members allowed him to take over the leadership of the Liberal Democratic Party (LDP) and with it the government of the country. He avoided the typical rhetoric of politicians, spoke in simple sentences, talked to the country about "no growth without pain," about "changing the LDP, changing Japan." He promised a "government of ongoing reforms." The parallels with the arrival of Matteo Renzi to power, and his profile (except the hairdo), are manifold.

Koizumi's government presided over the longest period of uninterrupted growth in Japan since World War II. It adopted an aggressive strategy of recapitalization and restructuring of the banking system. And it implemented a smart fiscal policy strategy, expansionary first (despite its initial message of reform and reduction of public spending) and contractionary only when the economy began to grow. But despite the appearances, it is doubtful the rapid economic growth was due to the cleaning of the banks (credit growth remained very weak). It is much more likely it was due to the very rapid growth of neighboring China. During the Koizumi government, Japan had the good fortune to benefit from strong demand stimulus—the same as Germany in recent years. As it is always the case, no demand stimulus, no growth.

But perhaps the most interesting aspect of Koizumi's tenure is what he said he would do but did not. Koizumi focused Japan's mandate on liberalizing the economy and reforming the political system. In addition to announcing reforms to reduce rigidities in many economic areas, Koizumi launched a flagship project, the privatization of the postal system. The Japanese postal system was the main source of indirect funding of the LDP, used to finance public works, which at the time were critical to ensure voters' support. Privatizing the postal system was an efficient way to reduce government spending and simultaneously end political endogeny, killing two birds with one stone.

Koizumi even called a surprise election to ensure the approval of the privatization legislation in parliament, creating a group of "assassins," young supporters who ran for election to oust the LDP deputies who were opposing privatization. Koizumi won the election with a large majority, and the privatization legislation was passed—but with a snag: Implementation was delayed to a very distant horizon, more than ten years.

And that was it. Koizumi lost interest and abandoned politics shortly after the end of his second term. The liberalization process ended up being minimal, and recently the postal system privatization legislation was amended to postpone the process sine die. At the end, despite all the fanfare, Japan faced the crisis of 2007 strengthened by Chinese demand but little else.

Italy faces a similar scenario. After several failed attempts, Renzi finally reached the leadership of the Partito Democratico earlier this year and became the head of the Italian government. He buttressed his position with a solid victory in the May European elections. The Renzi platform was simple: youth, charisma, break with the past, and reforms. It seemed that Italy had finally managed to achieve generational change without falling into Beppe Grillo's populism, freeing itself from the gerontocracy that had ruled the country for decades and hoping to, at least, release the country from the shackles generated by two decades of Berlusconi governments.

But it has been several months since Renzi's arrival to power, and unfortunately it is not clear whether Renzi is on track to be like Koizumi—lots of talk, little action—or whether he can achieve true change. Doubts are starting to increase. His economic plan seems fragile. Patience in Brussels and Frankfurt is starting to erode. The initial promise of implementing one reform per month has already been breached.

Perhaps that plan was too ambitious, and even counterproductive. Reforms, by definition, always generate side effects, and the combined effect of doing many reforms at the same time may not always be welfare improving. Perhaps it would be better to identify the two or three restrictions that most limit the growth of the country and eliminate them. Everything takes longer in Italy: firing and hiring employees, opening businesses, resolving lawsuits.

There is plenty of room to act decisively. The International Monetary Fund (IMF) in its recent Article IV consultation identifies four areas: the labor market, competition, small and medium enterprises (SMEs), and the judicial system. Creating the conditions to increase the size of firms is essential to boost productivity growth, and amending the famous Article 18 of the labor code is a key step.

The current strategy seems to be to first reform the senate and undertake economic reforms during the next three years. The senate reform is controversial, but it is easy, does not generate street demonstrations, and does not erode popularity. It is similar to Koizumi's postal reform. The hard part is creating the popular consensus to reduce the perks of the multiple interest groups that grip the Italian economy, facing the street if necessary.

Meeting the deficit target is not enough. It's the easy part and diverts attention from the main objective, increasing potential growth. Koizumi gave up; Margaret Thatcher persevered. Spain has been fortunate to have a program with the IMF, which forced the country to make changes that would never have been undertaken otherwise. Italy is going to have to do it alone.

Leaving the euro area, as hinted already by too many Italian intellectuals, will not solve the problem; it is like playing to tie under the old catenaccio soccer system. Italy is rich. It can continue its decadent and gradual aging, consuming its savings, lingering in the dolce far niente state waiting for a stroke of fortune to come to the rescue. Or it can wake up, take the bull by the horns, and progress. Renzi must decide.