Can they fix Italy?

Is Italy set to become the eurozone’s great anti-austerity rebel? Two days after being sworn in as the new Equal Opportunities and Sports Minister, German-born Josefa Idem said, “it is understandable that the people who are most directly affected by the crisis, and who draw a direct link with the austerity measures, hold an aversion towards [Angela] Merkel.” And Enrico Letta, the new Prime Minister, has said that Italy “would die of fiscal consolidation alone.”

Clearly, Letta is no anti-austerity fanatic. His Democratic party helped pass a series of budget cuts and tax hikes proposed by Mario Monti’s technocratic government, and he has promised that Italy will keep its finances in order—provided that it is given leeway to invest more to boost growth and create jobs.

The problem is that Letta is not leading a normal government. He is the head of a bipartisan grand coalition—perhaps the shakiest arrangement imaginable in a country with a fragmented political system and a long tradition of unstable governments. The fact that Letta’s coalition partner is Silvio Berlusconi adds to the uncertainty regarding the longevity and the direction of the new Italian government.

Berlusconi has played the hand he was dealt after the inconclusive elections in February extremely well. Although his historic ally, the Northern League, has decided not to join the grand coalition, Berlusconi’s centre-right bloc looks far more united than the centre-left at this stage—and its lead in opinion polls has been growing over the past few weeks.

Furthermore, the survival of the new Italian government depends on Berlusconi’s support. He can pull the plug whenever he wants and trigger snap elections that he would have a good chance of winning. This means his influence on Letta’s government is going to be significant.

Berlusconi embraced very aggressive anti-austerity rhetoric throughout the electoral campaign. He pledged to do all sorts of things to overturn what he criticised as German-imposed budget restraint: tax cuts, tax rebates, tax breaks, a tax amnesty and even a renegotiation of the EU’s fiscal treaty on budget discipline. His supporters now expect him to deliver on these promises, and Il Cavaliere will use all his leverage to push through his agenda. This might mean Italy taking a tougher anti-austerity stance in Brussels—which would set the scene for a confrontation with Germany and the rest of the eurozone’s “hawkish” core.

In a taste of things to come, Berlusconi has already threatened to withdraw his support for the new government unless a property tax on first homes (IMU) is scrapped—one of his flagship campaign pledges. The problem is that his policies come with a high price tag. Scrapping the housing tax alone, for instance, would create an estimated €4bn hole in the budget. It isn’t clear where the government would find the extra money. Italy sits on public debt of over €2 trillion, so its eurozone partners, the ECB and the markets would hardly be pleased about a new spending spree.

But the concerns over the stability of Letta’s government go well beyond deficit and debt reduction. Italy needs to embark on an ambitious path of political reform. The contorted electoral law (a key reason for the post-election stalemate) has to change. The same goes for the country’s institutional system, where the two houses of parliament have equal powers—something which inevitably slows down the law-making process.

Letta is renowned for being a patient and skilful mediator. He will have to strike a fine balancing act between his own views and the demands of his coalition partners. For the moment, he has given himself and his cabinet 18 months to make substantial headway on reform—otherwise he will be ready to quit.

After two months of post-election deadlock, every little step forward in Italy is being hailed as huge progress by politicians and the media. The country has managed to put together a new government, but its political system remains fragmented and the deep divisions among its main political parties have not disappeared overnight. As long as this inherent political uncertainty remains, Italy will continue to be a potential liability for the eurozone.