Matteo Renzi is fighting on all fronts. A fragile economic recovery and the ongoing refugee crisis have fuelled public anger, putting the populist Five Star movement ahead in the polls. The prime minister’s resolve to rescue Italy’s strained banks has added to tensions with Brussels. His plan for a referendum on political reforms, intended to give his government fresh momentum, may instead threaten its survival. Little wonder that investors now view Italy as the most immediate risk to the stability of the eurozone.
There is little to reassure them in the International Monetary Fund’s latest assessment of the Italian economy, published this week. Following the shock of the Brexit vote, the IMF expects growth to fall short of 1 per cent this year and barely to improve in 2017. It warns that Italy - the only major European economy that has not yet regained pre-crisis levels of output - is unlikely to pass this milestone until midway through the 2020s. The country faces two decades of lost growth, with knock-on effects for unemployment and real wages, over a period in which eurozone partners will have grown by some 20-25 per cent.
This lack of growth is the fundamental challenge Mr Renzi must confront. Italy suffers from low investment, low labour force participation and non-existent productivity growth. The OECD estimates its growth potential at a depressing minus 0.1 per cent.
These problems predate the eurozone crisis and the years of austerity. They appear to result at least in part from a longstanding misallocation of resources: skills and capital are not deployed in the most innovative companies, and there are too many small, unproductive businesses that do not grow. Italy’s banks have contributed to the problem with cosy links between lenders and the recipients of credit. Low growth now makes it all the harder to restore the financial sector to health.
The good news is that the reforms Mr Renzi has already set in train, in particular his overhaul of the labour market, are bearing fruit. Further reforms to make the legal system more effective; to boost competition in the services sector; help employers to move jobs to poorer regions; and to eliminate cronyism from the banking system could yield relatively swift results.
However, there is a limit to what European partners can expect of Mr Renzi in the coming months. His overriding priority must be to stabilise the banking sector. The IMF has suggested that this can be done without breaching EU bail-in rules; Mark Carney, the Bank of England governor, has also observed that recapitalisation may be necessary. It is to be hoped that Italy’s partners will be willing to take a liberal interpretation of the rules in order to resolve the current crisis.
They will also need to be understanding when it comes to fiscal policy. Italy has already won some much-needed latitude from Brussels; and tax cuts have helped to boost consumption. But if growth falls short of expectations this year, Mr Renzi may fail to meet his pledge to set debt on a downward trajectory as a proportion of gross domestic product. This should not be a concern. Fiscal loosening could be better targeted - for example, on public infrastructure investment - but this is no time to tighten the purse strings.
Finally, Italy’s partners need to recognise that a pause in unpopular structural reform is inevitable. Mr Renzi faces a risky few months in the run-up to October’s referendum, on which he has staked his political future. He remains Italy’s best hope for reform and a return to sustainable growth. Until the referendum is over, Italy’s allies will need to show patience.
