The fears of Brexit contagion may have seemed overblown after Spain’s election a week ago. But as Italy’s continuing banking crisis shows, the euro zone still faces major challenges. The European Union must act fast to change the vernacular of austerity that has alienated voters and restricted the ability of governments to put together policies for growth. Italy must be allowed to take a page from the Spanish playbook.

Spanish Prime Minister Mariano Rajoy’s decision in 2013 to reject EU-style austerity in favour of corporate tax cuts and some labour reforms helped pull Spain out of its economic recession. Rajoy set up a bad bank to bail out the distressed good ones like Banco Popular and Banco Santander, stabilizing the sector and unlocking lending to the real economy. His centre-right Popular Party has since suffered from a series of corruption scandals. But one convincing interpretation of the recent election in Spain, in which Rajoy’s party received the largest share of votes, is that the mayhem created by Britain’s vote to leave the EU proved so disconcerting that Spanish voters were not willing to risk the country’s recovery—3.2% growth in 2015—on a political fling.

Italy needs similar medicine (and more). With Italy’s non-performing loans at over 20% of GDP and the country’s public debt at over 130% of GDP, Prime Minister Matteo Renzi is running out of time. An EU-approved plan earlier this year to restructure the banks through the state-backed rescue fund Atlante has stalled. With only €4.25 billion ($4.8 billion), against €360 billion of troubled loans, the rescue fund always looked too small; it has failed to attract sufficient private money. Should Italian depositors lose confidence in their banks—still a very real possibility—the chaos would not only risk a financial collapse in Italy, but would spread through the euro zone. Shares in troubled lender Banca Monte dei Paschi di Siena is down 20% this week, with Italy’s La Stampa newspaper reporting on Tuesday that the government is considering a new rescue plan.

Renzi would like to aid the banks without forcing investors to share losses—politically explosive, given that 45% of bank debt is held by ordinary Italians—but EU state aid rules prevent that. He requested a six-month waiver of EU rules that require investors to be “bailed-in" for state aid to be given except in exceptional circumstances. Though Germany has objected, it has not closed the door entirely, no doubt recognizing that the alternatives to the current government are grim. Renzi, who has stood up to the European Commission in the past over budget restrictions, is likely to choose to break the state aid rules rather than risk a financial collapse and defeat in the October referendum.

Renzi’s dilemma is a reminder that the biggest barrier to the kind of growth-producing economic policies that both Rajoy and Renzi have advocated is not populist or left-wing opposition at home. It is, instead, the austerity orthodoxy that holds surpluses to be virtuous and deficits sinful, without considering individual circumstances and a blind adherence to growth-killing rules. This thinking forms a constraint on policymakers trying to unlock economic growth and reform and has provoked a backlash against the euro.

In its recent report, the Bank of International Settlements has argued for bringing prudential, fiscal and structural policies to the fore after a period in which monetary policy carried the burden. Germany could help by reducing its own fiscal and current account surpluses, which have contributed to rising levels of debt and unemployment in poorer euro zone economies that are unable to devalue in the face of the German exporting juggernaut. It should also show more flexibility to reformist governments in the euro zone.

Renzi has staked his job on whether voters approve his constitutional reforms in the October referendum. But the vote could easily turn into a vote of confidence in Renzi’s performance in office and even on whether or not Italy should stay in the euro.

Italy’s second largest party, the populist, Eurosceptic Five Star Movement, which has enjoyed gains in recent local elections, is calling for a wider referendum on Europe. Major elections in France and Germany fall not long after.

In the absence of a rebalancing in the euro zone and more flexibility for stabilizing policies and growth-producing reforms, Rajoy’s reprieve will be only temporary and no guide to what Renzi can expect in October. Bloomberg

Melvyn Krauss is a senior fellow at the Hoover Institution at Stanford University and an emeritus professor of economics at New York University.

Comments are welcome at otherviews@livemint.com

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