According to a statement by Berlusconi over the weekend, the resignations were a reaction to Letta's decision to allow an increase in the value-added tax (from 21 percent to 22 percent) scheduled for Oct. 1. During the campaign, the People of Freedom promised to lower taxes for households, including the VAT. However, Berlusconi's immediate goal in this current round of the crisis has been to prevent the Italian parliament from barring him from office after he was found guilty in a corruption case. Berlusconi has threatened in recent months that his party would withdraw support for Letta's government if he were expelled from parliament; a special Senate committee is expected to vote on Berlusconi's political future this week.
This is only a new phase in the ongoing political instability that has gripped Italy since November 2011, when Berlusconi was forced to resign while the country was under extreme pressure from financial markets. He was replaced by the technocratic government of Mario Monti, who relied on support from the People of Freedom and the Democratic Party to remain in power. Monti's government brought some temporary financial stability to Italy despite the looming threat of a coalition collapse. General elections were held in February 2013. The outcome was a parliament fragmented into three main groups: the Party of Freedom, the Democratic Party and the anti-establishment Five Star Movement, led by former comedian Beppe Grillo. It took several weeks of negotiation for the People of Freedom and the Democratic Party to form a new coalition, which has been extremely fragile since its inception in April. Berlusconi's perennial legal problems only made the situation worse, with the former prime minister constantly threatening to bring the government down.
As a result of this political paralysis, the Italian government has struggled to pass any significant legislation this year. It managed to annul an unpopular real estate tax known in Italy as IMU, but has failed to plug the budgetary gap this created. It was also supposed to freeze the VAT to encourage household consumption, but the current political crisis has forced Rome to postpone the decision to the end of the year. The Italian parliament was also supposed to amend the country's electoral law and start debating a constitutional reform to allow the creation of stronger governments and prevent the political fragmentation that has characterized Italy in the past few years. However, the debate around Berlusconi's future remained at the center of the political debate for most of the year, blocking other issues.
Future Scenarios
Letta said Sept. 30 that he would not rule out calling for a confidence vote for his government, possibly as early as Oct. 2. The Democratic Party is hoping to attract dissidents from the Party of Freedom and the Five Star Movement and independents to survive the vote. Some members of People of Freedom told Italian media Sept. 30 that the party could support Letta's government for a few more days so it can approve the 2014 budget. Even if Letta's Cabinet survives in the short term, doubts surrounding the sustainability of his government remain.
If Letta does not gain enough parliamentary support to keep his government afloat, President Giorgio Napolitano would likely first form a caretaker government in an effort to approve the budget for 2014 and to try to reform the electoral law. After that, he would probably dissolve the parliament and hold new elections, which would only take place some 45 days after the parliament is dissolved. But without a significant reform of the electoral law, new elections are likely to produce an outcome similar to what emerged after February's elections, since the Italian electorate is still divided into three large groups and no party would obtain the necessary majority to form a solid government.
Italy's largest parties are also going through internal crises. The Democratic Party is struggling to appoint a new leader, and will hold leadership primaries in December. The Party of Freedom is fragmented between hawks and doves, with some of its members not supporting Berlusconi's recent moves, which they view as bringing dangerous instability to the country. Finally, the Five Star Movement is also fragmented, since some of its members are increasingly questioning Grillo's political leadership and a few have even left the party. This means that early elections will likely not be enough to bring Italy more political stability.
Avoiding a Major Crisis in the Short Term
While financial markets and EU officials will express concern about the future of Italy, Rome is relatively safe in the short term. The promise of intervention in sovereign markets by the European Central Bank will be enough to prevent an escalation of the financial crisis in the eurozone in the coming weeks. Italy's borrowing costs have been rising recently (at times, they have gone above those in Spain), but are considerably below their November 2011 levels.
Italy's crisis, however, is inherently political. A combination of fragmented political parties, pervasive corruption, geographic economic inequalities and strong interest groups (from unions to business lobbies) have prevented Rome from applying structural reforms to improve Italy's competitiveness and restore economic growth. Italy was growing at meager rates even before the crisis in the eurozone, and Rome was unable to apply significant reforms even before its current political crisis. This is a reminder that political shortcomings in member countries also have a share in the explanation of the European crisis, and that political events in one country can spread through the financial markets to other countries in the currency union. On Sept. 30, for example, Spanish Prime Minister Mariano Rajoy expressed concern that the Italian crisis could lead to rising borrowing costs for Spain.
In this context, Italy is unlikely to emerge from its crisis in the short to medium term, so structural reforms will keep being postponed and little of the foundations of the country's crisis will be addressed. Italy was one of the few eurozone countries that did not emerge from recession in the second quarter of this year, when its gross domestic product contracted by 0.2 percent quarter-on-quarter. Economic activity is likely to remain weak, with unemployment (currently at 12.1 percent according to Eurostat) also likely to remain high.
This will lead to further social unrest, since the Italians are growing increasingly tired of their political parties. In this context, the Five Star Movement — or a similar successor — will have room for electoral growth, thus hurting Italy's traditional, pro-European elites. This comes at a time when other Euroskeptic parties are gaining strength in Europe. For example, in Sept. 29 Austrian elections two parties that reject the euro — the Freedom Party and Team Stronach — substantially weakened the ruling elites, though the elites maintained a tenuous hold on power.
A prolonged political crisis could also test the European Central Bank. Struggling eurozone countries such as Portugal and Spain saw a significant drop in their bond yields because of the European Central Bank's announcement of the Outright Monetary Transactions program, which allows the institution to purchase sovereign bonds in secondary markets to keep yields down. So far, the promise of intervention has been enough to prevent an escalation of the financial crisis in the eurozone, but the program itself has never really been tested. If the European Central Bank were forced to actually intervene in the financial markets, it would have to sign a memorandum of understanding with Italy, something that could be difficult without a solid government in Rome.
