On September 27th the Italian cabinet approved a budget deficit for 2019 of 2.4% of GDP. The aim was to boost the country’s lacklustre economic growth and fulfil at least some of the costly promises the two parties in the coalition had made to voters at the general election in March. The hard-right Northern League, headed by Matteo Salvini, promised to slash taxes. The anti-establishment Five Star Movement (M5S), led by Luigi Di Maio, offered an income guarantee for the unemployed and poor. Both parties favoured rolling back a pension reform so that some Italians will again be able to retire at 62 instead of 67.
Government representatives protested that the proposed deficit is well below the euro zone’s ceiling, of 3% of GDP. But the real issue is whether Italy can risk such largesse. Relative to the size of its economy, its public debt is the largest in the euro zone after that of Greece. Thanks to the heroic efforts of the previous, left-of-centre, government, it shrank slightly last year. But even so it still totals 132% of GDP.
The coalition’s target is 50% bigger than the biggest deficit officials had calculated the state could run without piling up more debt. It was three times what the previous government had agreed on with Brussels. And, said the technocratic prime minister, Giuseppe Conte, the plan was to hold the deficit at 2.4% for three years. As investors took fright, the government shifted ground, announcing that the deficit would be trimmed by 0.3 percentage points in both 2020 and 2021. By then, the Milan stockmarket index had lost 4.4% since the planned deficit was revealed, and the yield on Italy’s benchmark, ten-year bonds had reached its highest level since March 2014.
In Brussels European Commission representatives did nothing to comfort the markets, piling extra pressure on the government in Rome. The commission’s president, Jean-Claude Juncker, cited the danger of a crisis like the one that engulfed Greece and warned that giving Italy special treatment could even doom the euro (in absolute terms, Italy’s debt stock is far higher than Greece’s). Mr Salvini insinuated that Mr Juncker was a drunk.
The atmosphere is fraught. Yet surprisingly little is known about the government’s intentions. Detailed forecasts, meant to have been submitted last week, are still awaited. The budget itself will not be ready until the middle of the month. And ministers have given conflicting figures for the increased economic growth the government believes can be achieved by running a higher deficit. The saga could be protracted: the budget will take the rest of the year to approve.
Best of frenemies
Both sides are treading a fine line. The M5S has much to gain from sticking to its guns. It entered the coalition as the senior partner, having won a third of the national vote. Yet Mr Di Maio (pictured, large) has since had to play second fiddle to his fellow-deputy prime minister, the brash Mr Salvini (pictured, small).
The League leader has used his other role, as interior minister, to take a hard line on immigration that has almost doubled his party’s following since the election, to nearly 32% in recent polls. The M5S, by contrast, has slipped more than four points, to 29%. Mr Di Maio took on a broad portfolio encompassing industry and employment that so far has offered him fewer opportunities to grab headlines. But last month he at last put himself centre stage with a threat to block any budget with a deficit below 2.4%. After Italy’s non-political finance minister, Giovanni Tria, reluctantly gave in, Mr Di Maio appeared on the balcony of the prime minister’s office, jubilantly punching the air.
If the markets continue to turn against Italy, however, his joy will be short-lived. It will take time for the rise in yields to push up the government’s cost of borrowing, which rises only as debt is rolled over. The average maturity of Italy’s government debt stock is close to seven years. But by the end of October two ratings agencies, Standard & Poor’s and Moody’s, are due to review their classification of Italy’s bonds. Any downgrade could raise the government’s borrowing costs, soaking up cash it had planned to spend.
Foreigners have reduced their holdings of Italian government debt. But Italy’s banks still hold €370bn of their country’s bonds—10% of their assets. A sharp fall in bond prices would weaken their balance-sheets as funding costs begin to rise. Meanwhile, the European Central Bank is poised to wind down its bond-buying scheme, which will also act to push up yields.
Mujtaba Rahman of the Eurasia Group, a consultancy, says that the commission, too, will need to be careful. If it is soft on Italy, it risks being seen by member states as weak. But too hard a line could easily stoke further Euroscepticism ahead of the European parliamentary elections next May. A lot of Italians stand to benefit from the M5S’s handouts, or the lower taxes promised by the League, and will doubtless blame Brussels if they are not forthcoming.
In 2014 the commission successfully sought revisions to the spending plans of Matteo Renzi’s left-right coalition. Its reaction to Italy’s populists suggests it will seek changes this time too. And, says Mr Rahman, it might be prepared to veto Italy’s budget if not enough changes are made. That would be unprecedented and could eventually lead to sanctions.