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Aug 22, 2016 | 09:30 GMT

7 mins read

Reforms to Stabilize Italy May Backfire

Reforms to Stabilize Italy May Backfire
(GABRIEL BOUYS/AFP/Getty Images)
Forecast Highlights

  • Facing a key referendum on constitutional reforms, the Italian government will pressure EU governments and institutions to let it introduce tax breaks and increase public spending.
  • A defeat in the referendum would likely cause the current government to resign, but Italy will not necessarily hold early elections.
  • Political risk will continue to generate financial risk in Italy, especially if the government fails to introduce institutional reforms meant to increase stability.

When Matteo Renzi took over as Italy's prime minister in February 2014, he had two main goals. The first was to introduce a series of policies — most notably, a new labor law — to fight unemployment and generate economic growth. The second was to remodel Italy's political system to ensure more stable governments and to reduce the financial risk that political uncertainty posed. Though Renzi's economic reforms have been only moderately successful (unemployment is falling slowly, while growth has been timid), it is the political reforms that will define the future of his government and that could open a new phase of uncertainty for the rest of the eurozone.

Renzi's plan to build a more stable political system has two parts: reform the electoral law and change the Italian Constitution. The changes to the electoral law were approved in 2015, while the constitutional reforms will be put before Italian voters in a referendum before the end of the year.

Under the new electoral system, a party that receives at least 40 percent of the vote in a general election is awarded 54 percent of the seats in the Chamber of Deputies, the lower house of Parliament. If no party reaches the 40 percent threshold, a runoff is held between the two parties with the highest vote totals. The party that wins the runoff is given enough seats to give it majority control of the lower chamber. The goal of the reform is to create strong governments that are not under constant threat of collapse.

Renzi's proposed constitutional changes, meanwhile, are aimed at Parliament's upper house. If approved, the reforms would reduce the number of seats in the Senate and limit the body's participation in the legislative process. The Senate would no longer have the power to introduce a vote of no confidence against the government. Other reforms would shift some powers that currently belong to the regions to the central government. From Renzi's point of view, the next Italian government should control a strong majority in Parliament and wield more power than its predecessors.

Enter the Five Star Movement

The electoral and constitutional reforms were formulated and introduced at a time when the popularity of Renzi's Democratic Party was high and it appeared to have a good chance of winning a general election in the first round and of creating a strong government against the weak and fragmented opposition. But according to current opinion polls, the Democratic Party has the support of only 30 percent of voters, about the same as the anti-system Five Star Movement. If elections were held today, the Democratic Party would face the Five Star Movement in a second-round runoff as mandated by the new electoral law.

In countries such as France, the two-round electoral system was designed to prevent fringe parties from gaining power. That system has thwarted the ambitions of the National Front, a right-wing party that is unpopular with a large segment of the French electorate. In 2002, for example, National Front presidential candidate Jean-Marie Le Pen made it to the second round of balloting against Conservative candidate Jacques Chirac. In the runoff, Chirac attracted voters who, though they might have disliked him, were totally opposed to Le Pen. Chirac won in a landslide.

But the Five Star Movement is not the National Front, and the two-round electoral system in Italy might not propel the establishment party to victory as it did in France. The Five Star Movement and the National Front share strong anti-establishment agendas. Both parties criticize traditional political elites, and each desires to leave the eurozone. But unlike the National Front, the Five Star movement focuses mostly on fighting corruption and stresses the need to replace what it terms "professional politicians" with people who have no previous political experience. Unlike the National Front, the Five Star Movement does not have an overtly anti-immigration or anti-Muslim agenda and is not as focused on law-and-order issues.

As a result, moderate and independent voters would not necessarily reject the Five Star Movement in the same way that French moderates and independents eschew the National Front. Should the Democratic Party and the Five Star Movement reach the second round in Italy's general election, the upstart party could win. It is conceivable that parties including the right-wing Northern League and, perhaps less likely, the center-right Forza Italia could decide to support the Five Star Movement to defeat their rival.

Key Developments Before the End of the Year

Several developments have yet to unfold that could change who gains the advantage in Italy's complex political situation. The Italian Constitutional Court is scheduled to rule Oct. 4 on the legality of the electoral law. Should it decide that the law must be modified, the government could tweak it in a way that would hinder the Five Star Movement. Some members of the Democratic Party propose that instead of awarding the bonus seats in Parliament to single parties, they should be awarded to coalitions instead. The Five Star Movement, which has refused to form coalitions with other parties, could be hurt by such a reform. In addition, the Five Star Movement is undergoing its first real test of governance after it won municipal elections in Rome in June. A bad performance managing Italy's capital could hurt its national image.

More important, the constitutional reform referendum could pass. Though most opinion polls show that a slight majority of Italians will vote to reject the reforms, it is not necessarily because they do not like them. Renzi linked the referendum to his political future, which gave his opponents incentive to campaign against the reforms as a way to force his resignation. In the coming weeks, the Italian government will try to depersonalize the campaign, focusing on the institutional stability and monetary savings to be gained from the reforms rather than on Renzi's political future.

Rome will also negotiate with EU decision-makers to be allowed to introduce public spending increases and tax cuts before the referendum vote. Renzi is set to meet with French President Francois Hollande and German Chancellor Angela Merkel on Aug. 22, and again with Merkel on Aug. 31. He will probably push for their support for his public spending plan. In addition, the Italian government will present its 2017 budget to the European Commission in mid-October. Brussels will probably warn Italy about its deficit, but the commission is unlikely to propose sanctions against the country.

Should voters reject the constitutional reforms, Renzi would be significantly weakened, and he might even resign, but this does not necessarily mean that Italy would hold early elections. The Democratic Party could try to appoint a new prime minister without elections, a move that would require support from other parties. The largest parties in Parliament could also form a national unity government or even a technocratic administration, as happened in late 2011 when former EU commissioner Mario Monti was appointed. Parties currently in Parliament may decide to stay in power for as long as possible, considering that Italy does not legally have to hold elections until early 2018.

It is ironic that reforms meant to create more stability in Italy have generated new uncertainty about its future. This concern comes at a time when Italy's economic recovery is still fragile and when the effects of the Brexit referendum have reignited fears about the condition of Italy's banking sector. Italy, like France, had hoped to benefit from the realignment of political power within the European Union after the British referendum, but with Hollande's popularity at record lows and with Renzi's political future at stake, Southern Europe is not in the best position to lead the bloc.

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