By Steve Scherer and Gavin Jones
ROME (Reuters) - Prime Minister Mario Monti took power three months ago to rescue Italy from economic disaster. In one way, he may have done his job too well.
Monti's "Save Italy" austerity budget and his international credibility have helped bring the country' borrowing costs sharply down from levels that brought it to the brink of economic disaster in November.
But that in itself is taking pressure off the broad coalition of parties backing his unelected government of experts to sustain their support for vital reforms.
The parties only agreed to hand over their power when the crisis became a full-fledged emergency last year and Monti's scandal-plagued predecessor Silvio Berlusconi was forced to step down.
Italian benchmark borrowing costs have fallen to around 5 percent from a peak close to 8 percent in November, and the spread against safer German bunds has declined to less than 3.2 percentage points - its lowest since September - from highs above 5.5 points.
Monti can take much of the credit for this dramatic improvement in sentiment, but the downside is that it has lessened the sense of urgency needed to drive through unpopular reforms Italy desperately needs to recover competitiveness.
Critics are now accusing Monti of backsliding on his resolve to fix Italy in the face of pressure from vested interests.
"Monti is in the situation of having successfully saved the country, and paradoxically it's going to make it harder for him to do the reforms that are needed," said Alberto Mingardi, director of the Istituto Bruno Leoni, a Milan-based free-market think tank.
The risk is that while the country may already have avoided a spiraling debt crisis, without greater deregulation and labor market flexibility it may remain in the low-growth, high-debt trap in which it has floundered for well over a decade.
Legislation to put an end to old privileges in the services industry has been the object of a lengthy tug-of-war by rival factions in the Senate, and it has been watered down.
Taxi drivers thwarted an attempt to liberalize the issuing of new licenses to make the sector more competitive. This power remains with city mayors instead of in the hands of a new Transport Authority less susceptible to pressure by the powerful taxi lobby, as the government had proposed.
The government also dropped a proposal obliging consultants, architects and other professions to provide a written cost estimate before taking on a job. Lawyers managed to dodge the abolition of minimum tariffs, at least until the justice ministry can come up with a new way of calculating legal fees.
Mingardi said Monti, a former European competition commissioner, had given the impression that Italy was "unreformable" by backing down to powerful interest groups.
To avoid voting on 1,700 proposed amendments presented mostly by lobby-friendly lawmakers, the deregulation bill was passed in a confidence vote on Thursday. It now goes to the Chamber of Deputies for definitive approval.
Tito Boeri, an economics professor at Milan's prestigious Bocconi University where Monti was rector, said having given ground to political parties on the deregulation plan, the prime minister may find it harder to maintain momentum for a key reform of the labor market, promised by the end of March.
"There has clearly been a weakening of the deregulation proposals, and I also see risks for the labor market reform, which doesn't seem to be getting very far," Boeri said.
He said trade unions seemed to have managed to divert negotiations away from hiring and firing onto the area of broader welfare benefits for which there are scant resources, "increasing the risk that almost nothing will be achieved."
With an employment rate of just 57 percent, the second lowest in the euro zone, and youth unemployment at more than 31 percent, labor reform is vital for Italy's future.
Monti's government is in talks with the powerful unions on how to overhaul a "dual" labor market that offers heavy protection to salaried workers, and no security or benefits to millions of mostly young people on temporary contracts.
Italy's biggest union, the CGIL, has pledged to defend the controversial article 18 of the labor statute, which was adopted in 1970. It obliges firms with more than 15 employees to re-instate workers ruled to be wrongfully dismissed, with full payment of lost salary.
Monti faces a difficult challenge if he is to achieve a real reform that eases firing restrictions, makes it more viable for firms to hire people on regular contracts, and provides more training and benefits to the jobless.
The premier's high popularity rating, which polls put at just under 60 percent, should give him greater authority to tackle difficult reform, but to get the labor changes through parliament he will also need rock-solid political backing.
Monti depends for his parliamentary majority on the votes of both the centre-right, led by Berlusconi, and the centre-left.
While the centre-right defended the professional lobbies that were the original target of his deregulation plan, it is the centre-left, traditionally close to the trade unions, that has misgivings about labor reform.
Monti is trying to strike a delicate balance between rival factions that agreed to an awkward alliance when Italy seemed to be teetering on the precipice of default just three months ago.
Political insiders have repeatedly emphasized that Monti must be seen to be completely even-handed between right and left to sustain support in parliament, so that making concessions on deregulation could have a knock-on effect on labor reforms.
In more than two weeks of Senate haggling over the deregulation plan, Monti gave a little bit to both sides, allowing everyone to claim victory.
He backpedalled with the taxi drivers and lawyers, who are close to the centre-right, but took a tougher line against big business, especially banks. The introduction of virtually free bank accounts for low-income pensioners was particularly applauded by the centre-left.
"He's a good tightrope walker," said Maurizio Pessato, vice president of the SWG polling agency in Trieste. "He's successfully navigated the middle road between the two sides supporting him."
However, a growing number of commentators say Italy needs the kind of bold action that characterized Monti's austerity plan, which the parties were forced to swallow under the threat of sovereign default, rather than cautious tightrope walking.
Francesco Giavazzi, another Bocconi University economist and Alberto Alesina of Harvard, warned last week of the risk that he will avoid the major labor overhaul that is needed in order to keep support from business, unions and political parties.
"Making do with some marginal adjustments would be worse than not doing anything, because it would create the illusion that a problem has been solved when it isn't true," they said in a joint article in Corriere della Sera newspaper.
(Editing by Barry Moody/Janet McBride)