Ever since Italy’s insurgent populist parties forged an unlikely coalition government that started in June, their proposals for the 2019 budget this autumn loomed as a potential flashpoint with Europe. However far apart the right-of-centre League led by Matteo Salvini and the anti-establishment Five Star Movement headed by Luigi Di Maio were in their electoral bases and ideologies, they were united in stuffing their manifestos with costly commitments. That augured ill for the budget given the constraints set by fiscal rules policed by the European Commission.
That flashpoint has duly occurred, causing the yield on Italian sovereign debt to rise sharply as bond prices have fallen (yields are inversely related to prices). That’s a big worry for a country whose debt is stuck at around 130 per cent of GDP, a burden exceeded in the European Union only by Greece. Higher bond yields also hurt Italian banks, which embody the infamous “doom loop” between a shaky state and fragile banks through their big holdings of public debt, and their share prices have suffered.
The tremors in financial markets occurred as the two populist leaders insisted on a looser fiscal stance in 2019 than Giovanni Tria, an outsider university professor appointed as finance minister, had originally intended. Tria had advocated keeping next year’s budget deficit close to 1.6 per cent of GDP, the target it had inherited for this year. Instead this became a defiant 2.4 per cent, considerably higher than the 0.8 per cent envisaged for 2019 by the previous government. The extra borrowing will pay among other things for Five Star’s pledge to introduce a basic income for all.
Yet for supposedly fire-eating populists, their budgetary plans were arguably remarkable for their restraint rather than excess. The proposed deficit is comfortably within the limit of 3 per cent of GDP set by the Maastricht treaty of 1992—a supposedly sacrosanct threshold that has often been breached including by fiscal puritans such as Germany.
Indeed, Italy’s deficit for 2019 is less than the 2.8 per cent shortfall proposed by France under its impeccably reformist president, Emmanuel Macron. Admittedly, that headline figure includes a temporary cost of 0.9 per cent of GDP arising from a shake-up of payroll taxes. This means that it can be excluded from the structural budget balance (adjusted for the economic cycle and one-off measures), which features heavily in the Commission’s assessment. But it comes from a country that has been a serial offender in running a deficit above the Maastricht 3 per cent limit and whose public debt is close to 100 per cent of GDP.
“GDP per person fell by 3.7 per cent between 2000 and 2017”With both sides looking ahead to next spring’s European elections, a further escalation in the conflict between Italy and the EU is eminently possible. Salvini fanned flames on Monday when he branded European Commissioners as “enemies of Europe.” Yet there is nothing new about Italian governments picking an argument with Europe over its budget plans, which occurred for example in 2014 under Matteo Renzi, a former impeccably reformist leader. What this suggests is that for all the rhetorical duelling between the two sides there may be more room for compromise than currently appears possible. The Italian government has for example already trimmed its plan for the headline deficit in 2020 and 2021 from 2.4 per cent in each year to 2.1 and 1.8 per cent of GDP respectively.
Whatever the outcome of the dispute, the Italian populist government has picked the wrong issue in crossing swords with Europe over the budget, not least since any stimulus to the economy from the higher deficit is likely to be undone by higher interest rates. And it has picked the wrong adversary, which lies not in Brussels but at home. Instead the overwhelming priority should be to combat the real enemy, which is chronically low trend growth.
In 2017 Italian GDP was a mere 2.5 per cent higher than in 2000. Allowing for population growth, that has meant a decline in living standards gauged by GDP per person, which fell by 3.7 per cent over the same period. Even though the economy has been recovering in recent years, GDP in 2017 was 5.5 per cent lower than at its previous peak in 2007, before the financial and euro crises.
At the heart of Italy’s economic plight is a virtual standstill in productivity. In the long run, advanced economies grow mainly through sustained rises in output per hour worked. But in the past two decades this source of growth has been negligible in Italy as it has struggled to meet the twin challenges of globalisation and eurozone membership.
Italy’s fall from economic grace has been spectacular. In 1990, Harvard management guru Michael Porter praised the country’s clusters of small firms (such as in footwear) in his Competitive Advantage of Nations. That strength has turned to weakness as Italy has failed to develop sufficient big companies to master global markets. Competition from China and other low-cost Asian producers has hit prime industries such as textiles. Inside Europe’s monetary union, Italy has no longer been able to devalue its own currency in order to restore lost competitiveness.
Low growth makes Italy vulnerable to adverse debt dynamics, which occur when interest rates exceed nominal GDP growth. This causes public debt to balloon unless a country runs high enough primary budget surpluses (which exclude interest payments). This is why Italy cannot afford the surge in borrowing costs that has occurred this year as investors have run for cover.
The real worry about Italy’s populist rulers is not their fiscal provocations. Rather it is that their overall policies seem likely to brake rather than to accelerate growth. According to the IMF’s overview of the global economy out this week, Italy’s GDP will grow by just 1.2 per cent this year, dropping to an even more dismal 1 per cent in 2019. Understandably Italians became fed up with governments that had delivered too little on the economy. But by voting in the populists in the March election they have endorsed counter-productive remedies that will make the patient worse rather than better.
