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How do you get Italy to reform? Former European Central Bank board member Lorenzo Bini Smaghi has the answer: force it into a bailout. The snag is that markets are extremely unlikely to play along.
Mr. Bini Smaghi is right to highlight the fact that Italy needs far-reaching reform. The economy is likely to hit its seventh consecutive quarter of economic contraction, and it is stuck in its longest recession since 1993.
The current government – a shaky coalition between centre-left parties and Silvio Berlusconi's conservatives – looks ill-placed to make the necessary reforms to stimulate growth. That would include liberalising the economy and labour markets, and streamlining the public sector. Neither party will want to push through unpopular measures with a potential election looming at any moment. The current fragile equilibrium is unlikely to persuade Italians to spend, or companies to invest.
A bailout could provide medium-term certainty, through a clear conditional agenda for reform, but it isn't unlikely to happen. ECB President Mario Draghi's promise to save the euro has kept 10-year bond yields anchored at an expensive-but-not-terrifying 4 per cent. They may not fall much further, even if the ECB starts buying debt. So there is little incentive for Italy's politicians to seek outside help.
The risk is that reform will have to wait, yet again, until a deeper crisis strikes. Then emergency measures will rely, as usual, on immediate tax hikes, rather than on structural savings. Yet the next crisis is getting harder to predict. Debt is set to reach 132 per cent of GDP in 2014, but the country is increasingly less dependent on foreign investors buying its debt: Italy's current account balance has turned positive. It would probably take an extreme political upheaval to make yields rise substantially again.
Rather than waiting for the next crisis, the euro zone should encourage the current government to act now. It wants to stimulate growth by cutting some property taxes and give incentives for youth employment, all the while abiding by its requirement to keep its budget deficit below 3 per cent. One option would be to allow Italy to run a higher deficit, in exchange for serious reforms. With few sticks left, Europe needs more carrots.