Europe's recovery depends on Renzi's Italy

In spring, ambitious reforms began in Italy. Under Matteo Renzi, the ailing economy will either begin a real recovery, or slide further. The outcome is vital to Italy, Europe and the global economy.

Soon the name of Matteo Renzi, the new prime minister of Italy, will be known better internationally, after his meetings with German Chancellor Angela Merkel and President Obama.

Along with French President François Hollande, the two know only too well what's at stake in Italy's recovery. If it succeeds, the recovery of the euro zone will slowly continue. If not, the implications will be global.

Italian Prime Minister Matteo Renzi greets leaders arriving for a meeting of G7 leaders on March 24, 2014 in The Hague, Netherlands.
Getty Images
Italian Prime Minister Matteo Renzi greets leaders arriving for a meeting of G7 leaders on March 24, 2014 in The Hague, Netherlands.

The reform drive of il Rottamatore

One year after being sworn in as Mayor of Florence in 2009, Matteo Renzi declared that a complete change was necessary in his Democratic Party and Italian politics. So he was nicknamed il Rottamatore ("The Scrapper"). Last February, the 39-year-old Renzi became the youngest person in history to be Italy's Prime Minister — even younger than Mussolini.

(Read more: France to ply China with wine)

But can the Great Scrapper reverse Italy's economic decline?

First, the good news: In the end of 2013, only two months before Renzi arrived in Rome, the longest recession in Italy's postwar history ended.

The bad news is that, after nine consecutive quarters of negative growth, the economy is almost 10 percent smaller than before the crisis. Meanwhile, business continues to complain about the tax burden, and the unemployment rate has doubled to over 12 percent since 2007. Despite pledges of austerity in Brussels and Rome, Italy's fiscal deficit is 3 percent of the GDP and its sovereign debt has climbed to more than 132 percent of the gross domestic product (GDP). Among the EU members, only Greece has more.

The only bright spot is the current account surplus, which is almost 1 percent of the GDP. The positive turn stems from a higher contribution from net exports, coupled with a decline in imports. Nonetheless, it will be hard for Italian exporters to sustain their performance in the near future.

The economy suffers from a de facto process of de-industrialization. Industrial production has not increased ever since August 2011 and is now down 25 percent from its peak. Credit contraction weighs heavily on business confidence and consumer sentiment.

Ambitious programs — on a monthly basis

Today, Renzi's Democratic Party, Partito Democratico (PD), has its strongest constituencies in Northern-Central Italy and the big cities. PD runs 12 Italian regions out of a total of 20. It is social-democratic, progressive by outlook, reformist by inclination.

Renzi himself is perceived as a liberal modernizer. When he became prime minister, it was a sign of much-needed generational change in the aging Italy, in which potential growth amounts to barely 0.8 to 1 percent in the coming years.

(Read more: Russia's next step: Capitol controls?)

Italy needs huge structural and institutional reforms. Renzi hopes to reverse the country's longstanding decline by launching one large project every month, starting with a new electoral law to consolidate political decision-making, reforms in the public administration, and the tax system.

Even before Italy's European Council presidency will begin on July 1, 2014, Renzi hopes to achieve on a monthly basis what Rome's political class has failed to achieve in decades. After Berlusconi's rule, he sees Italy's political landscape as devastated. Even before his premiership, he suggested that Italy's parliamentarians should vote for their own removal. To become prime minister, Renzi politically maneuvered his predecessor Enrico Letta to resign.

Nonetheless, Renzi's program will initiate the long-needed transformation of Italy. If this program will fall apart, the failure could push the economy deeper into the abyss.

Slow recovery — or devastating depression

In the past, the euro zone avoided a major crisis as long as friction points were restricted to small economies (e.g., Greece, Portugal, Ireland), which each accounted for less than 3 percent of the euro zone GDP.

Everything changed in fall 2011 when the contagion effect reached Spain and Italy, which together account for almost 30 percent of the regional GDP. If, under these circumstances, Greece would have defaulted, it could have caused a contagion effect, particularly in Italy. That is why Greece has now received two bailouts (73 billion euros and 164 billion euros), is in talks about a third one (up to 20 billion euros) and more generous repayment terms.

As long as Greece remains solvent, Italy and Spain will have time to restore sustained growth.

(Read more: ECB's Weidmann says QE not out of the question)

The Italian economy remains vulnerable, however. Standard & Poor's still has a negative outlook on the country's "BBB" rating. Even by 2016, Italian economic output is likely to remain nearly 7 percent below 2007 levels. It is suffering from a "lost decade."

The stakes are massive. Italy continues to account for 5 percent of gross commercial long-term debt globally, although its population is less than 1 percent of the world total.

While Brussels has demanded tough austerity programs, an exclusive focus on the latter would only make things worse in Italy. Instead, Renzi's government is likely to reduce its huge debt only slowly, but focus on a lower deficit.

A failure to achieve progress would polarize Italy, destabilize Southern Europe and reduce global growth prospects.

How Italy goes, so will the world go.

— By Dan Steinbock

Dan Steinbock is research director of International Business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore). See also