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A Last Chance for Italy

Investors' love affair with Italian debt is on the rocks and will face tougher tests ahead. Foreign money returned to Italy last autumn with the European Central Bank's pledge to buy sovereign bonds from struggling countries in the euro zone's periphery. But this new confidence hangs by a thread, as Italy's inconclusive election raises doubts as to whether it will form a credible government that could meet the terms of ECB support.

Yields on Italy's sovereign debt have already risen, but may get even worse as investors realize that a left-right coalition government is destined for failure.

How then can Italy regain markets' confidence?

The country is almost certainly heading back to the polls in three to six months, given the distance between the Democratic Party (PD) and Silvio Berlusconi's People of Liberty (PdL) alliance on key areas such as labor reform and taxes. During this time, the political gridlock will give fertile ground to Beppe Grillo's Five Star Movement, which pledged to ally with no other party. His anti-austerity, anti-euro message appeals to voters who are angry at the old generation of politicians—the casta—responsible for the country's slow economic decline.

Yet Mr. Grillo's rise also gives an opportunity to Italy's mainstream political forces to finally wake up to Italy's problems and change their strategy. Both the PD and the PdL should use their time before a second vote to radically shake up their approach to politics and return to the electorate with a more appealing choice. The PD should ask itself whether Pier Luigi Bersani is capable of achieving a decisive swing next time around, or if he should leave room for a younger and more dynamic leader. Just as pertinently, the PdL must assess whether Mr. Berlusconi is still an electoral asset or a liability.

There isn't much time: The economy is getting worse. In this interim limbo, companies uncertain on the direction of future Italian taxes and reforms will freeze investment decisions and delay new hires. Banks will hold up new loans. Consumers will further tighten their belts. The longer the instability lasts, the more the recession could deepen, generating higher unemployment, defaults and bad loans.

Political anxiety could spill over to the banking system, too. In January, Italian banks lost €30 billion in deposits, according to the ECB. Unofficial news that Mario Monti's interim government was reconsidering €3.9 billion of public support for Banca Monte dei Paschi di Siena pushed the bank's bonds down more than 2 percentage points on Wednesday. The plan was formally approved on Thursday.

Finally, Italy's situation can cast broader doubts on whether the euro zone's austerity strategy is sustainable. It is a race between reforms and populism: Reforms and austerity are painful initially, and if they do not re-start growth quickly enough, populism takes over. The risk is that this could happen to other countries too, weakening the ECB's backstop even further. At that point, core European countries will face a dilemma—either give unlimited powers to the ECB and risk periphery countries free-riding on its support, or let populism rise and threaten the currency union.

It looks like a Catch-22 situation. New elections today would pose an even greater risk to stability. Mr. Grillo's Five Star Movement and Mr. Berlusconi's PdL gained ground over the days immediately before the elections on tax-rebate promises, pushing the Monti camp's support down to just 10% of the vote. On the other hand, living with a government that is unable to act is not an option. The longer the economy deteriorates, the more tempting these populist promises are to cash-strapped Italians.

Italians want change. They are right: Italy has seen little or none over the past 20 years of elected governments. Like a group of prima donnas, the existing old-school political forces continue to bicker around alliances, while bond yields rise and rating agencies threaten downgrades.

Instead, all leaders should stop arguing and rethink their strategy from the start. They should focus on three key points: reducing public debt, reforming labor and product markets, and cleaning up Italy's bureaucracy. It is in their own interest. They may soon lose their jobs if they don't.

This article was published on The Wall Street Journal on February 28, 2013.

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