Italy’s economy: Berlusconi’s desperate gamble

The prime minister's last-ditch hopes of pepping up a moribund economy may come to nothing

HIS back to the wall, desperately thrusting and parrying, the hero leaps for the chandelier. His assailants look on as he swings out of reach. Silvio Berlusconi may hope that he has pulled off a similar stunt with a pledge to slash taxes as a way of reviving both Italy's economy and his political fortunes. But his enemies, and even some allies, must wonder if he is more likely to come crashing to the ground.

On March 26th Italy's prime minister was firmly on the defensive. Several hundred thousand Italians took to the streets to ask what happened to the economic “miracle” he promised when he was elected three years ago. Trade unions said more than a million people marched in 50 demonstrations on a day of nationwide stoppages billed as a “general strike”.

The strike was called to protest against the government's pension reforms. But it turned into a general moan about the economy. It has become clear that Italy's stalled economy is an even more pressing concern for most voters than the government's unpopular reforms. The issue looks certain to dominate the regional and European elections in June, whose outcome may decide the fate of Mr Berlusconi's government. After all, the best - arguably the sole - reason for electing somebody with his doubtful political credentials was that, as a hugely successful businessman, he would know how to fire up the economy. Yet Italy is at a standstill.

That may have been forgivable so long as the rest of Europe, and indeed the rest of the world, was in the doldrums too. It is less so now that there is a global upswing, and even a glimmering of growth in Europe. In the fourth quarter of 2003, the euro area as a whole grew by 0.6%. Even Germany managed 0.2%. But Italy's moribund economy stagnated. The first quarter of this year may not be much better (though unemployment fell to 8.7% in January, down from 9.1% a year ago).

Mr Berlusconi's initial response to the strike was to renew a pledge he had made last year to slash the top rate of income tax from 45% to 33%. He then added another: to cut the number of public holidays. After protests from, among others, the Roman Catholic church, he finessed this into a plan to shift public holidays to the end or start of the week, to stop workers taking extra, unofficial days popularly known as ponti (bridges).

That would certainly raise output - a bit. Italians are not at the top of the international goof-off league (12 public holidays a year, compared with 14 in Spain and 15 in Japan). But it is hard to see this as a serious economic reform. Lower taxes would have a far bigger impact. By mid-week Mr Berlusconi seemed to be staking his entire political future on them. If by 2006 he had not cut the top rate to 33% and, he added, the lower rate to 23%, he would not even stand at the general election that must be held by then. By the beginning of May, he intends to outline plans for spending cuts of €6 billion ($7 billion), to pay for a first round of tax reductions.

Mr Berlusconi's characteristically bold initiative wrong-footed his coalition partners as much as his enemies. His deputy, Gianfranco Fini, of the far-right National Alliance, who has been calling in vain for ministers to get their policies endorsed by the cabinet before announcing them to the public, was clearly irritated. He gave warning that his party's support for the government was conditional on the benefits not going only to the rich.

But can Italy afford tax cuts at all? In the long term, said the economy minister, Giulio Tremonti, who clearly believes in the Laffer curve, the government expects lower taxes to finance themselves by stimulating growth, raising incomes and so restoring the shortfall in revenue. But in the short term, even Mr Tremonti concedes that there is bound to be a big gap. And he has ruled out cuts in spending on health, welfare or public-sector pay.

Some margin for manoeuvre exists. Officials had already listed around €3.7 billion in savings that could be made this year, and another €8.5 billion next. Mr Fini's misgivings no doubt owe something to the fact that the biggest single category earmarked for the axe consists of subsidies for the poor south, whence his party draws much of its support.

Mr Berlusconi wants to give away some €12 billion in tax cuts. But it sounds as if he is considering bigger budget deficits as part of the mix. He mused this week that busting the 3%-of-GDP ceiling imposed by the euro area's stability pact would “not be a capital offence”. Last year, Italy's budget deficit was 2.4%. But that was largely due to one-off measures. Without them, the figure would have been more than 4%.

Nick Eisinger, who monitors Italy for Fitch Ratings, sees the whole exercise as being “on a bit of a wing and a prayer”. He identifies two risks: “The spending cuts become difficult to implement, or the supply-side shock to the economy is not as big at the government hopes.” Vincenzo Guzzo, European economist at Morgan Stanley, reckons that, paradoxically, the effectiveness of the cuts could depend on keeping to the euro's rules. “If people perceive they are only being achieved with a higher deficit, they will think that they are not for good; and the risk is that additional income will be translated into higher savings and not higher consumption.”

Nor will lower taxes do much for deeper-seated flaws in Italy's economy which, some believe, are the underlying reason for its sluggishness. The country has too few big companies, too much regulation, poor competitiveness, and not enough investment in new technology.

Francesco Giavazzi, a professor of economics at Bocconi University, Milan, says that “the question [of Italy's growth potential] has been in the background for the last 30 years.” He argues that much of the Italian expansion since the oil shocks of the 1970s was down to reckless public spending in the 1980s, and a devaluation in the 1990s. With neither option now available, the faults of a structurally flawed economy are becoming starker. If this analysis is right, it will take more than a tax give-away to solve Italy's economic problems.