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Wall Street's Italy problem isn't just Berlusconi

December 10, 2012: 1:09 PM ET

What's scarier than the return of Silvio Berlusconi? For some investors, it's his likely opponent in the race to succeed Mario Monti as Italy's prime minister: Pier Luigi Bersani.

By Cyrus Sanati


Silvio Berlusconi is back.

FORTUNE -- Silvio Berlusconi is back -- and he's already causing trouble. The markets reacted badly to the news over the weekend that the three-time former Italian prime minister would lead his party in upcoming general elections. The news doomed Italy's technocrat-led government, forcing the current Italian prime minister, Mario Monti, to turn in his walking papers, plunging Italy yet again into political disarray. The markets did not like any of this -- Italian shares on Monday fell as much as 3.3% on the news, while yields on 10-year Italian bonds shot up as much as 0.36% to 4.88%, the highest level in months.

But while Berlusconi's potential comeback is disturbing, Italy hasn't done that much better under the leadership of the unelected technocrats. Italy needs major political and economic reform if it ever hopes to dig its way out of its sinking debt hole – something that neither Berlusconi nor his rivals can accomplish easily given the harsh realities of Italian politics.

It was only a year ago that Italy woke up to the news that Berlusconi was resigning as prime minister of Italy. Italian debt yields had soared to an unsustainably high 7% on concern that the country wasn't doing enough to address its fiscal woes. On his exit, the major political parties decided to elevate economist Mario Monti to prime minister in a bid to show the markets that Italy was serious about getting its fiscal house in order.

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Monti has tried to get Italy back on the straight and narrow but he needed a lot more time, power and vision to do it right. To his credit, in his first few months in office he quickly passed $20 billion in spending cuts, introduced a new property tax and was able to raise the retirement age – things that would have normally taken years to accomplish in Italy's notoriously dysfunctional parliament.

But the honeymoon quickly ended when Monti took on the nation's labor laws. Not wanting to upset the coalition, dominated by left-leaning parties with strong ties to labor unions, he was forced to back down from a number of reforms that would have made it easier to hire and fire workers -- a key to solving Italy's rising unemployment problem.

Despite all of Monti's best efforts, though, Italy remains a fiscal basket case. For example, while he was able to push through much needed spending cuts and raise revenue, the nation continues to run a budget deficit. Indeed, Monti's controversial actions have barely moved the needle, cumulating to a puny 0.5% decrease to the nation's budget deficit compared with the same time last year. Monti had promised to bring the nation's debt ratio down by 1.2% this year from 3.8% to 2.6%, but it is clear he won't even get close to doing that.

The price for all this austerity and tax hikes doesn't seem to have been worth all the trouble. Italy's economy is expected to shrink by 2.5% this year and is supposed to fall another 0.3% next year. The rising debt and shrinking GDP means that the country's debt to GDP ratio will move from 120% last year to 126% this year – meaning that Italy is more of a credit risk today than last year when yields were hitting all-time highs.

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Italy's biggest problem has always been its growth story. Indeed, the nation's economy has grown at an average rate of 0.2% a year for the last decade – a sad growth rate compared to its eurozone neighbors. Monti should have focused on reforming the nation's horrid business climate. Italy remains one of the worst and most corrupt places to do business – not just in Europe, but on the entire planet. The nation recently ranked 73rd in the World Bank's "ease of doing business" index, putting it in the bottom of the heap behind nations like Kyrgyzstan and Ghana. The country's total business tax rate as a percentage of profit remains one of the highest in the world at around 68%, depressing economic growth and encouraging cheating. And in enforcing contracts, Italy ranked an abysmal 160th behind places like Madagascar and Iraq – yes, Iraq.

Low growth coupled with austerity is a recipe for a Greek-style meltdown. Italy's unemployment rate is around 11.6%, which is up from 8.8% from this time last year.  That's a big move in such a short time. More troubling is that youth unemployment is at an abysmal 37%, illustrating the difficulty and apprehension employers have in hiring new workers. If labor laws aren't reformed, then Italy won't stand a chance of getting out of this downward economic spiral.

The markets are now understandably concerned as to who will take over for Monti. If the unelected technocrat couldn't even balance the nation's budget, how much faith should the markets have in one of Italy's elected leaders? The reappearance of Berlusconi is alarming but many on Wall Street and the City of London are equally alarmed by his center left rival, Pier Luigi Bersani, the head of the Democratic Party (PD), which maintains the largest number of seats in Italy's parliament. A former member of Italy's Communist Party, Bersani maintains close ties to Italy's powerful labor unions, which may or may not be a good thing here.

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Bersani may play Italian politics and protect his friends in labor or he may use his credibility with the unions to work out some sort of fair deal to liberalize the nation's employment market. Bersani says he is keen to take on employment reform and will continue where Monti left off if elected. But one thing seems to be clear; the markets won't be cutting Bersani as much slack as they did for Monti. If he is unable to extract some sort of meaningful concession with labor unions quickly, the markets will most likely turn on him like hungry piranhas, driving Italian bond yields back up to unsustainably high levels.

It is now up to the Italian people to decide whether they want to try something new and give Bersani and chance to lead Italy or whether they'd rather stick to the guy they know and vote Berlusconi back into power. Monti's hasty exit means that elections will be most likely held in February, two months earlier than originally planned. Bersani has momentum coming out the primaries, but Berlusconi has the charm, wit and cash to slow him down. No matter who wins, the key will be job market reform. If neither one gets that part right, the eurozone crisis will start to sizzle once again.

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