In June, when Italy’s populist 5-Star Movement (M5S) and the Northern League agreed to form the republic’s 61st post-WWII government, a conflict with the European Union became inevitable. Gone are the days of Mario Monti’s 2011-13 EU friendly technocratic administration and the amiable Renzi government which followed. A country with a government debt of more than 130%of GDP now has an openly populist leadership with expensive agendas – including a €780/ month basic income – and a confrontational style. On September 27th the cabinet approved a budget for 2019 with a 2.4% of GDP deficit, a clear departure from the path of Renzi administration, which in 2017 managed to balance the books. The budget is not in conflict with the Stability and Growth Pact’s deficit limit, which is 3% of GDP, but is seen as a deliberately move by the indebted nation in violation the commitment to strive for total debt of not more than 60% of GDP.
Predictably, the EU reacted with scepticism. The IMF predictably chimed in, advising Italy to abide by the ‘framework of the European rules ‘. Yields on Italian government bonds (BTPs) rose sharply. To add to the problems, Italy’s economy is slowing down, growing by 0.7% year on year in the 3rd quarter of 2018, the weakest quarter since 2015. The government forecasts 1.5% growth in 2019, but that is substantially higher than most independent estimates. Total output is still 5% lower than at the peak in 2008.
There are many reasons for this dire situation; Italy’s list of economic ills is long. The country ranks 111 out of 190 in the World Banks ‘Ease of Doing Business’ index and 79th in the Heritage Foundation’s economic freedom index, below all other major EU economies. The economy is dominated by small family firms, who face a barrage of red tape and difficulties obtaining credit from a notoriously fragile banking sector. Italy’s banks, long incentivised to lend to inefficient, outdated state-owned companies, hold €224bn of non-performing loans. In recent stress tests by the European Banking Authority Italy’s Banco BPM and UBI were amongst the worst performers. The labour market is rigid, though reforms in 2014-15 did address some of the worst issues with employment protection for permanent contracts, which may help address a catastrophically high youth unemployment rate, currently a staggering 34.7%. The demographic problems are well known, with a low and falling birth rate and a rapidly aging population. What is needed is drastic supply-side reforms and government belt tightening. What the government is offering is the opposite. The consternation felt in Brussels is understandable.
Italy has been in dire straits before. In 2012, the country was saved from a debt crisis by then ECB president Mario Draghi’s famous promise to do ‘whatever it takes’ to protect the integrity of the Euro. 6 years on, a new crisis looms. The systemic problems that plagued the countries once labelled the PIGS (Portugal, Italy Spain and Greece) have of course not been properly addressed. But the sad state of affairs in Italy should not distract from problems further north in the Eurozone. In France, President Macron’s concessions to the ‘gilet jaunes’ protesters will in all likelihood push France’s budget deficit above the EU limit of 3% and demonstrates the difficulties in reforming rigid labour markets in the face of special interests who refuse to give up on state guaranteed privileges. France has flouted the 3%deficit rule for a decade before Macron reined in spending but this time the stakes for the EU is higher if they refrain from any action. M5S leader LuigiDi Maio reacted with an unsurprising sentiment: ‘If the deficit/GDP rules are valid for Italy, then I expect them to be valid for Macron’. Speculation is now that rather than throwing the book at Paris, Rome may get an easier pass. The problems will of course accumulate.
The political spectacle of the day may be in Westminster, where Britain is fighting to leave the EU. When that’s over, the remaining EU countries are poised to resume the theatrics which brought the Eurozone close to the brink a few years ago. This drama is far from over.
Editorial note: On Monday 17th December 2018, after the publication of this post, the Italian government published a revised budget lowering the deficit forecast from 2.4% to 2.0% of GDP. This has not met the expectations of the EU, who merely called it ‘a step in the right direction’.