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The Draghi factor

Mujtaba Rahman is the head of Eurasia Group’s Europe practice and the author of POLITICO’s Beyond the Bubble column. He tweets at @Mij_Europe.

Much has been said about what Mario Draghi means for Italy. Not a lot has been said about what he could mean for the European Union. And yet, the appointment of the former President of the European Central Bank to head Italy’s new government could prove to be a gamechanger — for Europe, and for its economic prospects.

The European Commission is currently reviewing, informally, reform plans submitted by member countries in exchange for transfers and loans they hope to receive from the €750 billion recovery fund in the second half of the year.

Privately, senior officials are scathing about the proposals advanced by Paris and Berlin. With French President Emmanuel Macron distracted by multiple challenges at home, and German elections around the corner, neither government is keen to articulate plans to overhaul their economies, take on vested interests or focus on anything other than the pandemic.

This puts the Commission in a bind. If Brussels doesn’t challenge the EU’s two big member countries to do more, it can’t credibly push southern Europe either. But it also can’t impose reforms on countries that aren’t willing to do them — nothing hurts leaders’ legitimacy more than if they are seen to be taking “diktats from Brussels” (a charge French far-right leader Marine Le Pen constantly levels against Macron).

At the same time, if money from the recovery fund is perceived to have been wasted, it will erode confidence in northern Europe — including Berlin — that Brussels has the wherewithal to enforce the EU’s treaties, as well as support for fiscal transfers in the future.

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This is where Draghi could make all the difference — and actually turn the EU’s toxic “north-south” dynamic on its head.

Notwithstanding lingering divisions within his new majority, concerns over how long any Draghi-led government will last and the fact Draghi himself hasn’t said much publicly about his plans, the former ECB president is likely to press ahead with far-reaching reforms.

He’s likely to be helped in this by his domestic standing — public support for Draghi now stands above 60 percent, making him Italy’s most popular political figure — and a huge parliamentary majority.

Draghi will also be able to draw on his own expertise and understanding of Italy’s problems, and will likely want to slash red tape as well as address the deep-seated structural, administrative and judicial bottlenecks that have historically held back Italy’s ability to absorb EU funds.

Tax reform, active labor market policies as well as increasing the levels and efficacy of public investment are also likely to be priorities. The new government may also introduce more short-term stimulus, by extending and even increasing COVID-related furlough schemes, bringing Italy closer to its large EU peers.

By advancing more robust reforms domestically, Draghi will create space and precedent for the Commission to go back to Berlin and Paris and demand more. In turn, this will reduce the risk Brussels will be scapegoated for not properly enforcing December’s deal.

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Even if Berlin refuses to follow (as is highly likely), Draghi’s example may encourage Macron, who has reform written into his DNA, to abandon caution in his remaining months before presidential elections in April and May next year.

For the EU’s long term future, the returns would be significant. The recovery fund needs to succeed in a few test countries, such as Italy and France, to increase the legitimacy of fiscal transfers and the likelihood they could be used again in the event of a future crisis.

And the dividend doesn’t stop here. If the fund is successful in delivering reforms, it could also positively impact the discussion on what to do about the EU’s outdated and arcane fiscal rules.

This discussion, originally due to begin in March, has now been postponed until after Germany’s elections in September, after Armin Laschet, German Chancellor Angela Merkel’s heir apparent, spooked officials in Brussels by slamming the door shut on a trial balloon floated by the head of Merkel’s Chancellery, Helge Braun, to amend Germany’s constitutional debt brake.

But that doesn’t make the problem any less pressing. Beyond the health crisis lies a much more difficult question EU capitals must address: how and over what time frame the unprecedented levels of borrowing and spending the coronavirus pandemic has necessitated will be repaid.

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The application of the EU’s fiscal rules — the “Stability and Growth Pact,” which dictates member countries should aim for deficit and debt levels no greater than 3 percent and 60 percent of GDP respectively — will have to be tinkered with. Otherwise, the result will be unprecedented austerity next year. Even northern Europe recognizes this would be counterproductive.

The “general escape clause” that effectively suspended EU fiscal rules in 2020 will probably remain in place this year, as member countries negotiate what to do about the rules that have underpinned the euro since its creation.

The 3 percent and 60 percent are hardwired into the EU’s treaties, so they won’t change. However, the secondary legislation that implements the treaty might. This is where the “Draghi effect” could have an impact — by encouraging northern Europe to get behind a set of rules that are less obsessed with austerity and more growth-friendly, carving out space for member countries to undertake high-quality public spending to facilitate their green and digital transitions.

Far from being the subordinate previous Italian prime ministers have been to their masters in Berlin, Paris, the Hague, Brussels and even Washington D.C., Draghi is likely to play a different role.

If he is able to leverage the recovery fund — and make a success of reforms and spending in Italy — Draghi could transform the dynamic in Europe and fundamentally change its economic conversation for the better.

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