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Can Italy Be Fixed?

11:07 AM, Nov 18, 2011 • By DALIBOR ROHAC
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Mario Monti’s appointment as prime minister of Italy has given some hope to observers of the current crisis in the eurozone. Monti, a former student of Nobel Prize winning economist James Tobin at Yale and president of the Bocconi University in Milan, has strong academic and policy credentials. Assuming he can command sufficient political support for his cabinet, will Monti be able to save Italy’s ailing economy and bring the country’s public finances back in order?

Mario Monti

Mario Monti

The Italian prime minister might be a competent a technocrat, but the prospects for a major overhaul of Italy’s economy remain bleak. There are no quick fixes for the country’s problems, the major problems of Italy’s economy are deep and require complex and politically difficult reforms.

Monti’s cabinet will have to deal with the country’s enormous public finance problem. With a debt-to-GDP ratio of over 120 percent, the Italian government faces spreads in the neighborhood of seven percent – hardly a sustainable situation. The government may try to impose a serious austerity program, but that would risk further suffocating the stagnant economy.

An alternative to cuts is some form of default on the debt. Tyler Cowen points out that half of Italy’s debt is held domestically. In a somewhat unfair scheme, the government could apply a substantial wealth tax on all assets in the country and use the revenue to pay off the domestically held debt. A riskier option would be simply to default on the domestically held debt, while committing itself to honor the bonds held by foreigners.

Assuming away the political troubles associated with the move, this would not be a durable solution to Italy’s economic woes. Ultimately, the only way of restoring Italy’s solvency is to increase the growth of its economy. And that might be trickier than it seems.

There is some low-hanging fruit, such as fixing Italy’s disastrous tax system, which applies a net total tax rate of 68.6 percent to corporate earnings. This is the highest in Europe (the European average is 44.2 percent). While this needs to be changed, reducing the tax burden on corporations is unlikely to increase tax revenue in the short term, and could worsen the government’s fiscal position. At the same time, the cutting taxes would result in now enough immediate growth, given the overall size of the economy, to do much good.

Italy’s troubles are structural. The nation is characterized by the ubiquity of small, family-sized businesses. The country has the second-highest share of labor force working in companies with less than 50 employees, after Greece. The good thing is, there are a lot of charming family-run restaurants and specialist stores, but in modern economies the relative importance of this business model is in decline. So, while Italians might be good at running small family firms, those are rather poor drivers of growth.

Regulatory and tax reforms could help small businesses to expand. However, the effects of such reforms will be felt in years, if not decades. Furthermore, these reforms tend to be complicated. It is one thing to reduce corporate taxes, and it is quite another to try to grapple with all the bureaucratic barriers to competition that keep well-managed firms from expanding and poorly managed firms from disappearing.

Finally, by standards of the developed world, Italy is a deeply misgoverned place. According to the Transparency International’s Corruption Perception Index, Italy is more corrupt than many of the post-Communist countries of Central and Eastern Europe, including Slovakia, Croatia, and Macedonia. A recent study by the World Bank showed that Italy has been the worst performing country in the eurozone – worse than Greece – on three of governance-related measures: corruption, government effectiveness, and rule of law.

The high-profile scandals and the rising number of corruption crimes are only the tip of the iceberg. In Italy, both politics and business are interspersed with subtle networks of patronage that not only cripples policymaking but also corporate governance in banking and other industries.

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