THE OLD quip that the EU can only deal with one crisis at a time is about to be tested. The coalition in Italy between the Five Star Movement and the Northern League has not been formally finalised, but looks likely to go ahead (well, as likely as anything can be in Italian politics).
Italians have got used to broken political promises, but if the coalition agreement is implemented, it could blow apart the EU’s fiscal rules. By some estimates, it would push the budget deficit towards six per cent of GDP, compared with the EU Stability & Growth Pact limit of three per cent.
The combination of flat tax proposals (a two-tier income tax rate system of 15 per cent and 20 per cent), a citizen’s income of €780 per month, and reversing pension reforms by scrapping increases in the retirement age might have been expected to alarm financial markets. Italy already has the second largest public debt to GDP ratio in the EU, at 132 per cent.
Strangely, the alarm bells have not really sounded yet. Yes, Italian 10-year bond yields have increased, but at 2.3 per cent they are still way below the seven per cent levels reached in 2011-12. And yes, spreads have widened against German bunds and Spanish bonds, but not dramatically.
However, Italy is an economic crisis deferred, not overcome.
If the coalition’s fiscal proposals are fully implemented, talk of an existential crisis in the Eurozone will return. How on earth could the European Central Bank continue to purchase Italian government bonds, if Italy were in flagrant breach of the EU’s budget restrictions? The budget solution, of course, will be a fudge, with dynamic scoring, heroic fiscal multipliers, and exuberant assumptions of potential revenues from privatisation. Indeed, implementation of the fiscal stimulus is likely to accelerate economic growth in the short term (providing bond yields don’t spike further), boosting an economy which has seen far too little growth over recent decades.
In this scenario, Italy somehow struggles through as the EU turns a blind eye to the ballooning budget deficit. But what happens if the EU doesn’t turn a blind eye, and instead employs every means at its disposal to curtail fiscal largesse? In such circumstances, Italian politics could turn even more populist. The League is clearly eurosceptic, but the Five Star Movement has been more ambiguous with regard to the euro. This ambiguity could yet harden into scepticism.
The fiscal room for manoeuvre will also be challenged by financial markets, with Italy having to finance public debt equal to 17 per cent of GDP next year.
Meeting this target while curtailing speculation about euro membership and preventing a spike in bond yields will, to put it mildly, be a challenge.
The euro crisis has been in hibernation over recent years – as a result of bond purchases under the Draghi Plan. The Italian elections and coalition agreement have woken it up.
It still hasn’t quite got out of bed, but that is looking likelier, especially with the intense fears over the solvency of Italian banks. The published non-performing loan ratio for Italian banks is 17 per cent, compared with a global and Eurozone average of four per cent. This, of course, is the published figure – the real figure is much higher, and would soar in the event of a future crisis.
To read Graeme Leach’s piece for City A.M. in full, click here.