Italy: new government, same old problems

What a difference a summer can make! Against all the odds, Matteo Salvini, leader of the Far Right La Lega (The League) party, decided to pull the plug on Italy’s ruling coalition composed of his party and the populist Five Star Movement (M5S). He did this at the most unlikely of the times, right after the parliament went into its summer recess on 8 August. This has sparked yet another political crisis in Italy.

With The League booming in opinion polls, he called for ‘full powers’. Early elections would have likely translated into a landslide victory for the ruling Far Right-populist coalition. That new government would have also adopted a strongly Eurosceptic stance. It may have even opened the path for Italy’s own exit from the euro.

Instead, in less than a month, there was an unexpected opening for the Democratic Party (PD) to form a government with the M5S and avert what would have been the most Far Right government in post-war Italian history. President Sergio Mattarella, who has the institutional role of trying to avoid general elections, engineered a different majority based on the distribution of seats in the current parliament. The new government, a so-called ‘yellow-red’ coalition between the PD and the M5S, was eventually sworn in on 5 September.

While the left-wing Free and Equal group (LeU) quickly buttressed the M5S-PD government, Matteo Renzi, the architect of this new configuration, and his new Italia Viva party splintered from the PD on 17 September. Italia Viva and Renzi state that they remain committed to supporting the government.

Independent Giuseppe Conte retained his office as Prime Minister, with the support of the M5S. The League, which had climbed in national opinion polls to almost 38% support after May’s European elections, declined in the aftermath of their ouster from the government to approximately 33%.

In the blink of an eye, Italian politics have been turned upside down in ways that almost no one had anticipated before the summer. For example, M5S’ attitude towards the European Union (EU) has undergone a profound transformation since its national #OutoftheEuro campaign in 2014, although this transformation is far from complete.

Despite being the minority shareholder in this new government, the PD was given most of the economic and EU-related portfolios. This guarantees a constructive dialogue with European institutions, effectively ruling out a repeat of last year’s embarrassing budget row between Rome and Brussels.  Such divides can have serious consequences for the national economy as evidenced by a sharp widening of government bond yield spreads during the budget feud.

The PD appointments should help restore faith in Italy’s financial credibility. Roberto Gualtieri, the new Economy and Finance Minister, was a member of the European Parliament, where he chaired the influential Economic and Monetary Committee.  Conte has already proved twice capable to strike deals with European institutions.

With such personalities at the helm, financial markets greeted the turnaround by lowering the implicit premium for the redenomination risk of Italian government bonds from 70-80 base points (bps) to 20-30bps, and the narrowing of yield spreads to 140-150bps on a 10-year maturity.

Notwithstanding these signs of relief, Italy’s underlying budgetary and economic problems are unchanged and will continue to be a significant concern going forward. The new government programme is very light on substance and details. There is a will to change tack towards the EU on budgetary and migration matters, but very little of substance about how to boost Italy’s poor economic performance.

A coherent plan to enhance potential growth is missing as the current one contains many contradictory statements. It calls for an expansionary fiscal policy which directly conflicts with the other stated objective of maintaining healthy public finances. Reversing the unsustainable rise in spending on pensions introduced by the previous government will be a difficult political hurdle to overcome.

While this would be difficult, there are means of reigning in public spending. For example, the new government could transform the misguided basic income, the so-called ‘citizenship income’, into a mainstream EU flexicurity scheme. However, this could only happen gradually and would have to avoid inflaming the M5S’ political sensitivities.

Despite a number of reforms introduced over the past ten years, Italy’s structural position remains weak. Fortunately, the decline in nominal and real yields provides the country with much-needed breathing space and a chance to introduce reforms that will achieve higher potential growth. There is also the possibility to arrange a reallocation of resources within the budget and foster a steady decline in the debt-to-GDP ratio.

In the past, the pressure from Brussels for structural reforms and a disciplined fiscal policy would translate into a lever for domestic actors to make decisions that would have otherwise been politically and socially hard to accept or implement. It was a way to indicate policy objectives that were in the broader interest of the country and counterbalance the short-term interests of some politicians. European constraints had to be respected, albeit reluctantly, and responsibility shifted to the EU-level.

All of this is gone by now. The 2011 crisis devastated both the economy and, perhaps more gravely, the mechanism for achieving political consensus for reforms. Within this intrinsically fragile government, having full ownership of budgetary discipline and structural reforms is challenging. Any attempt to impose unpopular, socially harmful measures risks further boosting the popularity of the anti-establishment Far Right opposition led by Matteo Salvini and The League.

The fragility of an incomplete economic and monetary union makes the situation even more delicate. Without a full European Central Bank (ECB) backstop, both a safe asset and a Eurozone-wide fiscal capacity, the risks for Italy’s unsustainable debt dynamics remain all the more worrying. Ring-fencing Italy to prevent the rest of Europe from being affected by its problems will not be sufficient. Preparing for Italy’s default is not a good strategy either.

The anaesthetic provided by ECB’s ultra-expansionary policies and Italy’s fragile pro-European government might not be enough to withstand the pain of the next recession.