Police take on students opposing a neo-fascist party in Milan, Italy. Picture / AP
Police take on students opposing a neo-fascist party in Milan, Italy. Picture / AP
This Sunday will see an election in Italy that could have significant consequences throughout Europe. The ruling Democratic Party has recently been fading in the polls and the Eurosceptic Five Star Movement is the most popular single party.
Moreover, other parties in the centre-Right coalition, which is leading in the polls, also take a predominantly Eurosceptic position. So it seems entirely possible that Italy will soon have a government of a notably Eurosceptic disposition. Would this matter?
First, the background. On the face of it, the Italian economy has recently been doing pretty well. Growth this year should be about 1.5 per cent, roughly the same as last year. This may not seem particularly impressive but it is a dramatic improvement on what went before.
Since the euro was formed in 1999, the Italian economy has grown by a mere 8.3 per cent, equivalent to only 0.4 per cent per annum.
But this does not mean that everything is well. Unemployment remains a huge problem. The headline rate is running at almost 11 per cent and youth unemployment is at over 30 per cent.
Moreover, as a share of GDP, government debt is over 130 per cent, exceeded in Europe only by Greece. Indeed, the Italian government bond market is the third largest in the world after the United States and Japan.
While other peripheral members of the eurozone have made considerable progress in improving their competitiveness vis-à-vis Germany, Italy has made none.
The Italian banking system remains highly risky, with bad and doubtful debts running at threatening rates. Within the eurozone's monetary system, the Banca d'Italia is a large debtor to the ECB, to the tune of about €400 billion ($673b).
Meanwhile, Germany's creditor position continues to get larger and larger, prompting increasing anxiety in Germany about its exposure, particularly to Italy.
Italy needs a sustained period of good growth, both to reduce unemployment and to set the government finances on a sustainable path. There is little in the Italian economy to give cause for optimism.
In particular, there have been no radical reforms to raise productivity and make the economy more competitive and flexible. Accordingly, if the world economic recovery were to falter, there is every reason to believe that Italian economic performance would slip back to the recent inadequate level.
The head of the anti-immigrant League, Matteo Salvini. Picture / AP
There are several distinct risks that could materialise after Sunday's election.
Perhaps the most obvious is that the result will not be conclusive. It is highly unlikely that a single party, or perhaps even the centre-Right alliance, will win an overall majority. Accordingly, a coalition government would have to be formed.
In the post-war period, it has been normal for Italian governments to last for only a short period and political instability has been the norm.
You may well conclude from this that Sunday's election result is likely to produce something quite negative in the sense that it will usher in a period of instability and uncertainty. But, bearing in mind the history, you could readily counter that this is something that Italy is well used to.
More important is Italy's position in the euro.
It is possible that sustained weak economic growth could cause parties to revive calls for a referendum on Italy's continued membership of the euro. Picture / AP
While most parties have recently rowed back on strident Eurosceptic rhetoric, it is possible that sustained weak economic growth could cause them to revive calls for a referendum on Italy's continued membership of the euro. If they ended up by promising such a vote there would inevitably be a period of uncertainty.
As we know from the UK case, referendums do not always follow the script written for them by the political establishment. That said, recent opinion polls have suggested that a clear majority of Italians favour continued membership of the euro.
Nevertheless, there have been some interesting ideas floated recently for a new parallel currency which might allow Italy to escape from the euro's constraints and lower its exchange rate, while not formally leaving the currency union. If the bond market got a whiff of something like this happening it would be extremely concerned.
Nor are financial risks confined to the euro.
All three leading opposition parties favour radical tax reform. Forza Italia favours a flat income tax of between 20 per cent and 25 per cent, while the Northern League has suggested a rate of 15 per cent. This compares with the current system where rates vary between 23 per cent and 43 per cent. These measures would be accompanied by reductions in the rate of corporation tax.
Fundamental tax reform is necessary in Italy, as it is in many other countries. And lower and flatter taxes should be a central part of this. But so far we haven't seen convincing proposals about the expenditure side of the equation.
Naturally, optimists believe that such tax reductions would lead to a surge in economic growth and tax compliance that would make the reductions more than self-financing.
And occasionally something like this can happen. But it is not bound to, despite widespread belief in such a fairytale ending within the US Republican Party.
If the tax reductions were not self-financing then what could be done?
The options are to cut government spending commensurately or to allow the budget deficit to rise. Given the fraught state of Italian politics, however, much economic logic might dictate a cut in government spending, this would be extremely difficult to deliver.
So the likely outcome from the introduction of a flat tax system accompanied by lower rates of corporation tax is a rise in the government's budget deficit and, accordingly, a deterioration in the outlook for the ratio of government debt to GDP, which is not exactly a recipe for financial stability - in or out of the euro.
Italian operas tend not to be among the longest in the repertoire but neither are they particularly short. Their plots are often contrived and their endings dramatic.
Even after Sunday's elections, the current political and economic drama probably has several more scenes to play out. But there is a limit to the time over which Italy's political and economic stagnation can be stretched.
