On June 5th, the European Union began a process of opening Excessive Deficit Procedures (EDP) against Italy, which could culminate in a multi-billion Euro financial penalty. This article outlines the internecine clashes within Italy alongside disagreements between Rome and Brussels and explains why this creates future economic risks, further burdening the Italian economy.
EU angst towards Italy
Italy’s economy suffers extremely high levels of public debt, stagnant growth and a fragile banking sector. Its exorbitant level of public debt sits at 132% of GDP, second only to Greece in the Eurozone. An uneasy compromise was reached in December by agreeing with the EU to reduce its deficit target from 2.4% to 2.04%. However, an uninspiring outlook for Italy’s economy has meant the European Commission remains sceptical of its budget deficit and debt levels. Pierre Moscovici, European Commissioner for Economic and Financial Affairs commented on the 2019 Spring economic forecasts that weak growth combined with a no-policy-change assumption could increase this deficit to 3.5% of GDP in 2020. Good reason is required when budget deficits do not run corollary with EU rules and Brussels believes these are not forthcoming. Meanwhile, a power shift in the populist government in Rome has seen The League’s Matteo Salvini gain ascendancy from a strong showing in May’s European elections exacerbating tensions in the coalition.
The EU’s Stability and Growth Pact enshrines a 3% government deficit and debt of 60% to GDP limit on Eurozone members, Italy contravenes both of these. In fact, national debt has steadily risen since the last compromise was reached in December. Finance Minister Giovanni Tria claimed a recession during the second half of 2018 has caused the overshoot. However, the EU is suspicious of a populist government which pays little attention to the Union’s fiscal regulations. Italy’s ruling parties are happy to flout the rules and seek to placate voters by cutting taxes and increasing public spending. Alongside the economic rancour are other simmering disputes over migration policy and China courting Rome through its Belt and Road Initiative.
Internal coalition squabbles
Domestically, Italian politics faces an awkward predicament. The Five Star Movement (M5s) were routed by their coalition partners The League, who gained 34% of the vote last month, double that of their counterparts. This is significant because it shifts the dynamics of the coalition considerably. Suspicions abound of Salvini calling a snap election, seeking to jettison the M5s and search for other populist coalition partners, whereby he could disobey the EU’s fiscal rules further. The run-up to the European elections was fraught with coalition infighting. Ultimately, the M5s and League hold different assessments of international relations. Their European policies are juxtaposed on many topics thus forming a cohesive policy around the Euro and European integration has proved fruitless.
Differences over domestic fiscal policy have played out visibly during the fortnight since European elections. Salvini has utilised this newfound prominence to announce a 15% flat tax rate, whilst Di Maio the leader of M5s has pushed for a ‘citizens income’ which does little to quell public spending. Rumblings of the creation of a parallel currency to alleviate government debts make many suspicious of the populist government forming a mechanism to depart the Eurozone. Many view raising VAT as a means to reduce the deficit. Yet the populist government has continually avoided the policy, for fear of reprisals at the ballot box. Concerns that Italy, like last year, will fail to publish a budget in line with EU rules has resulted in Prime Minister Giuseppe Conte threatening to resign if the issue is not swiftly resolved. This is worrisome for Brussels because Conte cuts a far more conciliatory tone to the EU than Italy’s two populist deputy-prime ministers, as he openly advocates to abide by EU fiscal rules.
The EU will take Italy to task over their fiscal obligations, but any imposition of fines is currently improbable. The first element of Excessive Deficit Procedures (EDP) will see the EU asking Italy to take remedial steps to reduce its deficit, as seen last December when an uneasy compromise was struck for the budget. Such fiscal punishment can extend to 0.2% of GDP, roughly €3.5bn in Italy’s case. Yet, since the establishment of the Euro, these fines have never been utilised. For now, to protect the Eurozone, the Commission will attempt to assist Italy cut its costs and bring it out of EDP, in a similar fashion to Spain. The EU formally announced it was abrogating such procedures against Spain on June 5th, the same day it opened proceedings against Italy. Expect the next steps to be taken at the European Council meeting on June 20th.
However, Italy’s greatest fear should not be the EU, but the markets. This political and economic uncertainty shakes confidence and pushes up yields on Italian sovereign debts. The Bruegel Institute has posited how these increased yields are becoming a burden for the real economy impacting the private sector by “making credit more expensive and scarcer.” This uncertainty has already played out; five days after the European elections, the yield on Italy’s five-year government bond climbed higher than a similar Greek security for the first time since 2008.
Italy also compares poorly against Spain, with the interest rate on a ten-year bond nearly 2% higher on the same maturity for Italian sovereign debt. Allowing activity of the markets to curtail Italian borrowing is preferential for the EU, as it seeks to avoid highly publicised cantankerous dispute with Italy by handing down fines. Equally, Salvini seeks to use the EU as a scapegoat for his policies and it will be wary to play into his hands. In 2011, the government of Silvio Berlusconi collapsed partially due to debt crisis, fortunately for the EU, Salvini is curtailed by similar forces.