Prodi’s choice

Date: 27/02/1997

SO FAR, Italy has been led a merry dance by the euro 'in-crowd'.

One day, one of the self-righteous five - Germany, France, the Netherlands, Belgium or Luxembourg - reminds Italy that it, with them, was a founder member of the European Communities and there will be no prejudging who will be in or out of economic and monetary union.

The next day, one of the Bundesbank's seemingly incessant stream of quotable council members, or a minor politician in the deutschemark-bloc, is licensed to rubbish Italy's chances of joining them in EMU-land less than two years from now.

The 'good cop, bad cop' routine has hurt Italian Prime Minister Romano Prodi's feelings. Fresh from his second visit within a fortnight to Bonn to see German Chancellor Helmut Kohl, the premier let it all out.

“It is puzzling to me that every other day, someone is authorised to say that Italy or Spain should not come in,” he said. Moreover, he added, faced with a persistently high budget deficit and rising unemployment, Germany was hardly in a position to lecture Italy on economic rectitude.

He has a point. On the face of it, Italy is no longer Europe's lost cause. An Italian economist who fell asleep ten years ago and woke up today would have to pinch himself. With inflation under 3&percent;, a budget deficit close to 6&percent; of gross domestic product and falling, and a stable government - at least in Italian terms - the country is a shadow of its former self.

Even that does not tell the whole story. Once interest payments on debt run up in the past are taken out of the equation, the government is running a considerable budget surplus. If it had not been for a succession of spendthrift governments and a profoundly corrupt political culture, Italy would now be laughing all the way to EMU and the European Central Bank.

Prodi still thinks that is possible.

For him, as for so many other desperate European politicians, the only Maastricht Treaty target that matters is bringing the budget deficit down to the magic 3&percent; of GDP. Given that the deficit was 6.6&percent; last year, hitting this target by the end of 1997 is a tall order.

The Prodi government pushed through two significant budget-cutting packages last year, designed to raise 40 billion ecu. But not even that was enough and the government was forced to confess last week that yet another mini-budget would have to be voted through to raise a further 8 billion ecu.

The risks are high. Significant spending cuts or tax increases could tip an already delicate economy into recession, while a budget of weak measures might fail to do the job.

Some details of the new mini-budget have already been leaked to the press and appear to amount to another round of fiscal tinkering rather than an attempt to address Italy's longer-term structural problems.

The most important element seems to be a new tax on state pensioners, which may target those who retire early and double as a disincentive. This alone should raise close to 2 billion ecu. Another tax, this time on company severance pay, looks likely to be brought forward a year from its anticipated starting date.

The government is also contemplating extra cuts in healthcare, including higher prescription charges, an increase in the number of people liable to pay emergency care fees, and higher drugs and general practitioner consultation charges for people above a specified income.

Economists appear to believe that the government could avoid sparking a counter-productive recession which would only serve to depress tax revenues and worsen the deficit.

“As long as there are no structural measures - like there were in last year's mini-budget - the effects on the economy should be quite slim,” says Carmen Nuzzo, an economist at Salomon Brothers investment bank.

The other good news for Prodi was last week's blessing from the EU's statistical office for his 'Euro-tax' - a levy on last year's declared income designed specifically to push down the 1997 deficit in time for EMU qualification, most of which will be repaid after 1999.

This is precisely what worries the single currency front-runners, but it took Belgian National Bank President Alfons Verplaetse to say it out loud. Verplaetse expressed concern about countries (he diplomatically named no names of course) with deficits close to 7&percent; which managed to reduce them to 3&percent; over one year alone, insisting this was no test of sustainability.

Everybody admires former UK Finance Minister Nigel Lawson for his extraordinary crash diet. Yet what is everyone's first reaction? Shock, followed by whispers about serious illness.

Italy's turn around has indeed been remarkable, but what it needs is at least three years of genuine structural reform. This should be done not just because the Italian establishment wants to swap the lira for the euro, but also because it is needed.

As Ricardo Barbieri, an economist at JP Morgan investment bank, puts it: “Real cuts should hurt and I do not see too many people in Italy screaming at the moment.”

Perversely, the Maastricht targets are increasing distortions as the government abandons all other policy goals except that of trying to dip under 3&percent; by December.

Italy needs major cuts in the public sector wage bill and the state pension system but, above all, it needs more and steadier tax revenues. If this could be achieved by reducing widespread evasion rather than higher taxes, all the better, but it also requires a shift from taxing companies on to taxing people. Privatisations could raise as much as 50 billion ecu, according to some estimates.

If the Prodi government is brave enough to make these changes, say analysts, Italy would thoroughly deserve a place at the EMU table.

However, some of those speaking out against Italy's candidacy suggest a longer wait and raise the spectre of a growing northern European prejudice against southerners.

After all, this is a country with a huge public debt, a tradition of political corruption and the threat of a split between its north and south. But the same could be said of Belgium - yet nobody is speaking out against its chances of signing up to the euro.

The northerners' fears are based on classical economic theory - much of which makes no sense, according to Gerald Holtham, director of the London-based Institute for Public Policy Research.

Their main argument is that Italy will be keener to borrow in a shared currency (in this case, the euro) than it is in the lira. Since its government would be part of a greater whole, it would feel happier to over-borrow since the interest-rate cost of this profligacy would be shared by all other members.

“This suggests that governments will be more ready to borrow in a currency that they do not control than in one which they do control,” says Holtham.

“That must be wrong because the Italians do not do it now, even though they could borrow in yen at 3&percent;. They just do not do it because this is a currency they do not control. Countries will be less willing to borrow in euro, not more.”

The other abiding fear - that the Italian representative on the European Central Bank would always vote for lower interest rates because that would reduce the cost of his country's debt - is hard to imagine as long as the Bank of Italy's hard man Antonio Fazio is alive and kicking.

As has been said many times about the politics of EMU, European politicians would do everyone a favour if they just told the truth.

Italy is not ready for monetary union, but it will be very soon. Instead of forcing through another package of fiscal finessing, Prodi's government could emulate its German or Dutch counterparts by making real long-term reforms if it knew it had an extra three years.

And Italy could still join before the euro notes and coins appeared in 2002. Would that really be so bad?