Pedro Szekely

La bella Italia, it may be the world’s most admired country for its rich history, beautiful cities, the most UNESCO monuments of any country in the world and of course its wonderful food. However, it’s also known for the mafia, the big economic divide between north and south and its tumultuous politics. Recently, all the remorse of the Italian people about these factors seems to have been outed in Italy’s parliamentary elections. Here, the far right party Northern League and the left-leaning populist party Five Star Movement (M5S) got a combined majority. They have now formed a government, and the policies they are enacting could be a potential danger to the stability of the European Union.

Let me give a quick overview of the policies agreed upon. The economic reform most heard of is the basic income instituted for low income households of 780 euros. There will also be large tax reductions and the retirement age will be lowered. This is a potential reason for conflict with the EU, since the measures will mean an increase in spending of 109 to 126 billion dollars a year. Italy will no longer comply to European budget rules, or even try to do so. The Italian government will also start taking protectionist measures against companies that do not keep their production in Italy. Other important reforms of the new government concern immigration, which will get a much more repressive treatment.

 

Doomsday is coming for the EU

These new Italian government poses a threat to the Italian position in the EU and even the EU as a whole. Firstly, Italian politics tends to be a good predictor for the rest of western politics. The Italians were the first to introduce fascism in the form of Benito Mussolini and the first to introduce populism with mister bunga-bunga Silvio Berlusconi. The new Italian government is now again the first example of a western European country with a complete populist and Eurosceptic government. If it proves successful in curbing immigrant inflow and raising the welfare of Italians through deficit spending, it could mean people in other countries would also like to go the Italian way. If multiple EU-member states get a euro-sceptic government, that could mean the end of the European project.

It is also possible that the new policies have a destabilizing effect on the Italian economy, and especially its government financing. As you can see in the graph below, the Italian debt-to-GDP ratio is high relative to other European countries, with only Greece outpacing it. At 130 percent, it far outpaces the European rule of 60 percent. However, the graph also shows that most countries don’t achieve the 60 percent norm, not even Germany. Also, the Italian debt may be high, but it’s also relatively stable since 2012.

Source: Eurostat

But the new government’s policies could mean the end to this budget stability. The proposed increases in spending and tax reductions are met with a austerity of a mere 0,5 billion euros. Thus it is likely that the budget deficit will increase and thus the debt-to-GDP ratio will start to increase again. This wouldn’t be major problem if the debt wouldn’t have been as high as it is. But at the level of debt Italy has, rising debt levels may make investors lose faith in Italy’s ability to pay its debt back. This will increase interest rates on Italian debt and in turn will make it harder for Italy to finance its budget deficit.

Another cause of concern is that interest rates have started rising again now the world economy has recovered from the 2008 crisis. The American Central Bank, the FED, has already increased its interest rates now that the American economy does quite well, in order to combat inflation. Draghi, chairman of the European Central Bank (ECB) has announced last week that the quantitative easing (QE) program will be ended by the end of this year. QE has been beneficial to countries like Italy that run high budget deficits and have high levels of sovereign debt, since their interest costs were lowered. Now that interest rates are increasing again, running budget deficits becomes more expensive for governments. This is not a major problem for most governments since the good economy also means higher tax incomes, higher economic growth and higher inflation (which means you can ‘inflate’ your debts away). However, Italy has shown rather low growth rates and its tax cuts and increase in spending will likely increase the budget deficit. Countries like The Netherlands or Germany could responsibly raise their expenditure, but Italy is creating a growing debt burden which could result in a debt crisis.

Source: Eurostat

And since the exposure of the financial system to unstable Italian debt poses a threat to the European financial system, the EU will do everything to keep an Italian spending spree from happening. The inability of Greece to finance its debt forced the other EU countries to help it out financially. If Italy gets into this similar situation, it will be a lot harder for Europe to help them since Italy’s GDP is 10 times as large and Italy’s debt is seven times as large as Greece’s. Add to that Italy’s relatively unstable and undercapitalized financial sector and you get why the European Commission and ECB look anxiously at the current developments.

And although the current Greek government was elected as a protest against the Troika-forced austerity measures, it did eventually comply to the demands of its creditors and the Troika. Even recently Greece has implemented new austerity measures to curb its budget deficit. The new Italian government however seems less enthusiastic to conform to Brussels’s and Washington’s desires. Both the M5S and Northern League are openly Euro-skeptical. In one of their leaked draft coalition agreements, leaving the euro was even mentioned. So if the new government does throw Italy’s government spending off the rails, it’s unsure if the new government will take the necessary measures to stabilize it again.

 

All will probably be fine

Greece is also the prime example of how European stability will probably be maintained. The Syriza party of prime minister Tsipras was elected with the promise that the Greek population would no longer have to suffer under the dictated from the Troika. But Syriza eventually took the same painful austerity measures. Once bankruptcy looms, even populist governments don’t see any other choice than the impactful austerity they protested against to be elected. This won’t be any different in Italy. If it ever comes that far, the new Italian government will see no other choice than to comply to budgetary rules. Otherwise, they won’t be able to pay healthcare, pensions and schools, which would mean major political backlash.

The leader of M5S, Luigi di Maio has also pledged that the budget deficit will be maintained at the current level of 1.5%, which is comfortably below the 3%-rule of the EU. This is hard to imagine given the policies that have been announced, so either these new policies will have to be weakened or Di Maio probably won’t be able to keep this promise.

The current minister of finance Giovanni Tria has also confirmed that Italy will stay in the euro and will focus on structural reforms instead of deficit spending. The financial markets seem to believe him, which has resulted in a decrease of the interest rates on Italian bond after the new government was installed. Although the yield is higher than under the last government, it is stable.

The situation for the Italian financial sector is also improving. The most recent financial stability report by the Italian Central Bank, Banca d’Italia, states that capital reserves in banks have been increasing sharply. This despite the historically undercapitalized nature of Italian banks. This decreasing the vulnerability to external shocks. The Italian financial sector is thus more prepared to endure a sovereign debt crisis, which exposes the rest of the EU financial sector to less risk. The Banca d’Italia does show its concerns about Italy’s high sovereign debt, which could become a problem when financial markets react negatively to changes in growth rates. But seeing the current economic growth in the EU, this may not be a large issue at the moment.

 

To conclude, the Italian government debt is not something to be light-hearted about. The new Italian government could destabilize the just stabilized situation with their radical policies. This could mean a serious danger to the stability of the EU if not dealt properly with. However, the current government does not seem to look for major confrontation with the EU. This would mean the inability to pay for public services and therefore political suicide. The days of the European Union are not yet numbered, but it’s in our best interest to keep an eye out.