Italy picks a fight with Brussels

Talk about “a poke in the eye for Italy’s European partners,” says the Financial Times. Italy’s new administration has announced that it plans to run a budget deficit of 2.4% of GDP for each of the next three years. Italy already has a heavily indebted economy, with national debt of 130% of GDP. It also has a lacklustre economy, with GDP rising by a mere 1.2% year-on-year in the second quarter of 2018. So the prospect of adding more annual borrowing than expected to the debt pile, with little prospect of growth working it off any time soon, rattled markets. The yield on Italy’s ten-year bonds jumped.

The budget proposed by the ruling coalition between the anti-establishment 5-Star Movement and far-right League puts Italy at loggerheads with Brussels. EU fiscal rules require a country whose debt stands at more than 60% of GDP to ensure its debt falls each year. To that end, Italy was supposed to cut its annual overspend sharply. So much for that.
A U-turn
The new deficit target “tramples over economy minister Giovanni Tria’s initial intentions,” writes Lisa Jucca in Breakingviews. The former economics professor originally announced he would draw a line in the sand with a deficit of 1.6% of GDP. But “political leaders with generous electoral promises to keep had other ideas”. Their new budget proposes to set aside €10 billion for a “citizens’ income”, a kind of universal income. The plans also include a cut in the retirement age, which will see pension spending balloon.
It’s worth noting that the deficit figure of 2.4% does not breach the EU fiscal limit of 3% of GDP. And it’s below France’s 2.8% planned for 2019. But Italy had promised it would rein in its debt, so EU authorities would find it hard to play along. “Accepting such a budget would be condoning truculent behaviour and economically misguided objectives.”
Heading in the wrong direction
To make matters worse, this furore is taking place against an inauspicious backdrop. “The economy is uncompetitive and the banks remain weak, which will weigh on productivity growth. Meanwhile, the demographic outlook is poor”, says Jack Allen of Capital Economics. Italy’s debt ratio will keep rising. The “surest recipe for debt reduction (and keeping investors on side) is supply side reform” to boost growth potential, says Nick Andrews of Gavekal Research. But Italy is “heading in the other direction”. Credit ratings agencies will be unnerved. Does the populist coalition have “any conception what a downgrade to junk would do to demand for Italian debt,” says Eoin Treacy on Fuller Money. “Large pension funds which have been gobbling up Italian debt to capture the higher yield would be forced to sell in the event of a downgrade.” Meanwhile the European Central Bank is winding down QE, so “there will be a hole in demand for the bonds”. With yields spiralling, a debt crisis, and the prospect of Italy defaulting and crashing out of the eurozone, could soon follow.