(forthcoming in Foreign Affairs)

Since the onslaught of the 2008 financial crisis, many economists had been forewarning the EU nightmare scenario now unfolding: a slow but inescapable domino effect as the economies of Greece, Ireland, Portugal, Spain, and Italy (the PIGS, or PIIGS for the Italy-pessimists) collapsed. Yet most observers got the ordering wrong: the crisis arrived in Italy before Spain. The reason is political: it boils down to the difference between Zapatero, a leader who resigned after realizing he had lost the political backing necessary for difficult reforms, and Berlusconi, an autocrat who has reluctantly resigned only on Saturday, despite losing the majority in Parliament on Tuesday, once the Financial Stability law was approved in Parliament thanks to the abstention of the opposition.

In fact, the standard question facing Italians has been why they put up for 17 years with such a controversial and “colorful” leader, one who had managed to collect an impressive record of criminal proceedings (corruption, bribery, minor prostitution, mafia connections, false balance sheets, false testimony), but went acquitted for all of them. La Repubblica explained that that many Italians, including Berlusconi, had been living in a sort of Truman Show, fabricated by the television stations Berlusconi himself owned.

Financial markets have been living in a dream world, too. 15 years ago, Italy’s joining the euro eliminated the currency risk associated with Italian debt, bringing down the average interest rate on its debt from 10 percent to below 4 percent in 2011. This reduced the country’s interest service bill from 12 percent to 4 percent of GDP in the same timeframe. All of this seemed like a significant improvement in the budget, but since 2004, the trend weakened. In 2005–06, coinciding with the third Berlusconi government, the debt/GDP ratio started to climb back. In 2008–11, the debt ratio reached its 1996 level, about 120 percent of GDP, while the primary (non interest) balance fell in negative territory: fifteen years of progress were squandered. In the meantime the economy stagnated, as the promised “liberal revolution” remained in the realm of dreams.

As it became clear that the EU had neither the resources, nor the political will to bail out Italy, the financial markets woke from their slumber. The first serious political blow to the government occurred in July 2010, when the Freedom Party’s co-founder and President of the House of Deputies, Mr.Fini, was expelled from the party for contesting the boss leadership. The party’s split almost provoked the fall of the government, but Berlusconi provided a quick fix by “shopping” in the opposition’s ranks. In exchange for government lucrative positions he gained the vote of a small number of centre-left MPs [who ironically called themselves the “Responsible Group”].

Yet, the heightened political instability pushed up the cost of debt, only to recede a few months later. August 2011 marks the true beginning of the end. The conflict between the Freedom Party and the Northern League on budget adjustment measures boarded to farce: significant measures, such extra taxes for the rich and more stringent controls on tax evaders’ bank accounts, where abandoned after being announced. The state of confusion and the paralysis of the government became self-evident and markets lost confidence: and interest rates were climbing again. In the end, the specter of a default ultimately dethroned the Sultan.

So what will happen after Berlusconi? On Wednesday, President Napolitano appointed Professor Mario Monti, the President of Bocconi University and Ex European Commissioner, as Life Senator. In this position, Monti, a new member of the Senate, will be able to take part in the political debate. It was a shrewd political move, meant to protect Monti from allegations, from right and left, of being “technocrat”, representing “Masonic and “Plutocratic” vested interests of “financiers”. Napolitano is rushing in the new government, whose new Ministers will be sworn in on Sunday, before markets open. But it is an open question whether Monti will succeed in having a durable majority in Parliament. One has to remember that one of the worst inheritances of the Berlusconi era, in addition to a prehistoric view of women in society, the idea that the servility to the powerful matters more than merit, and the idea that the rule of law is just an option, is a deeply divided country.

Berlusconi was the arch-enemy of the left and messiah-like for his own constituents. This is going to be a formidable obstacle for Monti’s government. Berlusconi’s own party is also deeply divided, with hawks (many ex-socialists and ex-fascists, whose political destiny is most closely tied to Berlusconi) calling for new elections, and doves (ex-Christian Democrats) supporting Monti. And the main opposition party, the centre-left Partito Democratico, fares no much better. It is divided between those who favor short-term “governo tecnico”, with a limited mandate for a handful of reforms, and those who favor a political national “save-the-country” coalition.

The worst case scenario for Italy will be if Berlusconi’s party initially pretends to back a Monti government, so as not to appear as “irresponsible” before the elections, but soon backs off whipping up fears of communism (for example if Monti introduces a tax on property). They soon withdraw their support and new elections are called. The heightened political uncertainty and the skepticism on the center-left’s ability to carry over the required structural reforms, leads to soaring spreads, Italy filing for IMF support, a debt roll-over crisis, possibly with a bank run (Italian banks hold 43 percent of outstanding government debt), and ultimately leads Italy to restructure the debt. Germany, France and Holland break away from the Euro1, say in one year or so.

The best case scenario would be if the doves on both sides get the upper hand and a Monti government is voted in. There is a strong commitment to support the government for a limited time, say eighteen months and to have new elections in mid 2013. Some agreement on equally distributed “sacrifices” and reforms is agreed upon. Interest spreads fall, and Italy slowly recovers. The Euro does not break up (at least for the time being).

Which scenario will materialize will depend largely on the influence of President Napolitano relative to Berlusconi’s remaining grip on his (personal) party. The larger the role of the President the lower the probability of a financial meltdown. But Professor Monti will need all the political dexterity he is endowed with: should he engage in political negotiations on the program, in order to get a wide political mandate, but with the risk of being dragged into lengthy compromises? Probably not, he should probably opt for the more risky strategy of making a take-it-or-leave-it offer on the basis of the program already agreed with the ECB and the EU.

A high profile new government, in the favorable scenario, will not only save Italy from default but will also avert the break-up of the Euro. The empirical evidence suggest (2) that the current Italian troubles are largely homemade and not the result of contagion from Greece or Europe. Actually, it’s the other way around: it’s the Italian crisis “infecting” other European countries. So what will do for Italy will do for Europe.

The what-do-to list has been known for years: cut the amazing costs of politics, to send a clear message that politicians’ privileges are no longer tolerated; reform the pension system, particularly the “seniority” pensions that sent thousand under-forty to retirement, in the North, and the (fake) “invalidity” pensions, in the South; crack down on tax evasion, estimated around 30% of VAT, and on the black economy, around 17 percent of GDP; reform the dual labor market, where hyper-protected middle aged industry workers coexists with hyper precarious young workers in services; abolish professional orders (lawyers, journalists, notaries, taxi drivers…) and their formidable barriers to entry; reform the tax system by shifting the tax burden from firms and labor to consumption and rents.

Will Italians accept to swallow the bitter pill(s)? Yes, but only if everyone else is seen swallowing one. And only if Italians, with Mario Monti, will be able to re-discover the meaning of an idea that Berlusconi always ridiculed: the idea of a “common good”.

References
(1) Manasse, Paolo (2011), “Berlusconi nel “Chart of the Day””, Back-Of-The-Envelope Economics, 11 October, 2011.

(2) Manasse, Paolo and Giulio Trigilia (2011), “The fear of contagion in Europe”, VoxEU.org, 6 July.
(3) Manasse Paolo, “ Berlusconi and Credibility”, Back-of.the Envelope Economics, / November 2011