Italy’s public finances. In a hole

Date: 10/06/06

Romano Prodi's government faces up to the need for fiscal austerity

ONLY in Italy could austerity measures be ushered in over dinner at a luxury hotel. Last weekend the new centre-left prime minister, Romano Prodi, and his cabinet repaired to a former noble retreat in Umbria. After hearing from the finance minister, Tommaso Padoa-Schioppa, about the dire state of the public finances, ministers enjoyed a five-course feast featuring truffle and pigeon risotto.

Self-denial does not come easily to Italians, as is shown by their national debt, the world's third-largest. Mr Padoa-Schioppa, who once served on the board of the European Central Bank, seems determined to give them some practice. Shortly before going to his first meeting of European finance ministers, Mr Padoa-Schioppa announced that deficit-cutting measures were "unavoidable". A detailed review of the public finances had concluded that, without corrective action, the deficit in 2006 would hit 4.1% of GDP, against the 3.8% hoped for by the outgoing government of Silvio Berlusconi. Indeed, the gap might easily be as big as 4.6%. The euro-area's stability pact supposedly sets a ceiling of 3%.

Mr Berlusconi also came to office in 2001 claiming that his predecessors had been cooking the books, so a touch of scepticism about the new numbers is forgivable. But there is no doubt that the fiscal position has deteriorated: the "primary" surplus (ie, before interest) that was built up in the late 1990s has largely disappeared. A supplementary budget this year was inevitable; the only debate is over what sorts of measures it should contain.

Last week, the central-bank governor, Mario Draghi, argued that growth should be the "absolute priority". But Mr Padoa-Schioppa seems to feel that fiscal discipline is more urgent, if not necessarily more important, than other economic reforms. The arguments in his favour are powerful. As a share of GDP, Italy's debt rose in 2005 for the first time in 11 years: it is now 108%. Two of the three main rating agencies have issued warnings of possible downgrades that would increase the cost of debt servicing. A failure to act could pitch Italy into a vicious downward spiral in which rising debt costs make it impossible to contain the deficit. The improving European economy may create a window of opportunity in which to implement measures that should, with luck, merely restrain demand, not suffocate it.

Yet there is a counter-argument, put forward this week, unusually, by both trade unions and employers. More deficit-cutting, said the leader of the CISL union federation, could "prevent us from latching on to the recovery". And Luca Cordero di Montezemolo, head of Confindustria, the bosses' federation, said that the government "ought to renegotiate with Brussels" to win more time to cut the deficit.

Such views could gain wider support as the political implications of Mr Padoa-Schioppa's austerity become clearer. Spending cuts and tax rises tend to fall more heavily on the poor, whom the centre-left are pledged to defend. The main plank of Mr Prodi's election campaign was a promise to cut payroll taxes by five percentage points, so as to reduce the "tax wedge"--the difference between a worker's take-home pay and his cost to an employer. Mr Padoa-Schioppa may now seek agreement from his colleagues to postpone the payroll-tax cut until the public accounts look healthier. But that is asking a lot of politicians whose government teeters along with a wafer-thin majority.

The new Italian government under Romano Prodi has to face up to the need for fiscal austerity.