The Italian Budget: A European Economic Crisis?

Written by Jake Kochanowsky (Wesleyan University)

While all eyes are fixated on the chaotic Brexit negotiations, another major political story is unfolding in Italy. After emerging victorious from a contentious parliamentary election earlier this year, the Italian Five Star Movement (MS5), a far-right populist party, has formed a coalition government with the League, another conservative party. Together, they have attempted to follow through on campaign promises by proposing a radically modified government budget that will increase government spending for the Italian welfare system. Internationally, the budget has been deemed as illogical as a result of Italy’s history of economic struggles and growing debt. The EU’s concerns about the budget are legitimate and even necessary to prevent severe political and economic repercussions, yet the Italian government is resistant to EU conformity and any reduction of its sovereignty over domestic policies. It is a tenuous situation, and Italy’s major role in the Eurozone as its third largest economy lends it additional urgency. In this paper, I will consider why the Five Star Movement insists on its impractical budget and what the economic and political consequences of this budget are as it stands. Despite its commitment to its campaign promises, MS5 and its ministers must consider alternatives to its budget; otherwise, the country will face an economic recession that will harm the world economy. 

Capitalizing on rural frustration with establishment politics and Italy’s large influx of immigrants, the MS5 successfully won control of the Italian Parliament in the 2018 general election. The party promoted itself on the promises that it would deport illegal immigrants and focus its internal policies on creating jobs and lowering the national tax rate.[1]The hope these policies engendered in supporters generated enough momentum to carry the party to power in the Italian government via a coalition with a similar right-wing party, the League. Compelled to follow through on campaign promises, Luigi Di Maio, Matteo Salvini and many MS5 leaders adjusted the Italian budget to cover higher government expenditures. Motivated by the welfare of their constituents, the MS5-led parliament has proposed a new budget that includes allowing retirement as early as the age of 62, instead of 67 years old, and introducing a “citizenship income” or basic welfare level of €780 a month for the poor and unemployed.[2] Most importantly, they plan to cut the income tax which will be split into two brackets, with citizens paying 15% or 20% of their annual income.[3]

The proposed budgetary modifications are unpalatable to the EU since the new budget will raise Italian deficits on its GDP to 2.4%, an increase from 0.8% in the original budget.[4] While this deficit isn’t above the EU’s hard cap of 3%, Italy’s economic woes over the past two decades and stagnant growth have many in the EU Commission worried about the consequences this budget will have on the Italian economy and the EU’s economy as a whole. Furthermore, the EU wants member states to avoid breaching a public debt ceiling of 60% of GDP. Italy, with the second highest debt in the EU, already sits at 131% of its GDP.[5] This staggering debt figure has rattled investor confidence and decreased bank loans, interest rates and the strength of the euro, compelling the EU to intervene.

Accordingly, the EU has responded to this “serious non-compliance” to existing economic regulations by condemning the Italian budget and threatening disciplinary action.[6] Moving forward, the EU Commission has started a process which will create a timetable for the Italians to modify their budget; if they do not comply, they will face fines up to 0.5% of their GDP (roughly €9 billion).[7] It is in both parties’ best interests to avoid this scenario, but the Italian government has not been receptive to EU feedback. Italian Prime Minister Matteo Salvini reflected the opinion of the Italian people when he responded, “the EU should respect the Italian people considering Italy pays the EU €5 billion more than it receives.”[8] This statement is reflective of the Italian attitude towards the EU as 52% of Italian citizens are anti-EU. This sentiment has been driven in recent years by the recent dependence in the EU on its larger nations, such as Italy, to pay a higher portion in taxes while receiving less money back in subsidies and investment. Additionally, the EU’s immigration policies run contrary to the MS5’s platform and has added to the tensions between the current government and their EU counterparts. However, despite the majority Euroscepticism in Italy, don’t expect the Italians to leave the EU just yet. The Italians may remain adamant about their budget and cynical of the EU Commission’s suggestions, yet it is important that the Italians at least consider the feedback in order to maintain their position in the EU and prevent their economy from weakening further.

It is evident Italy is attempting to veil its euro-skeptic attitude, and instead is demonstrating specious optimism regarding the budget by proffering an argument that lacks data and statistical evidence.  EU criticism of the budget has noted that in a situation of extremely high debt, Italy is planning significant additional borrowing rather than fiscal prudence. Commission VP Valdis Dombrovskis stated, “the uncertainty and the rising interest rates are taking their toll on the Italian economy. Also, it hinders the ability of Italian banks to lend to Italian companies and households at affordable cost.”[9] The Italians disagree with this analysis; instead, they suggest that their borrow-and-spend policy would boost economic growth, reduce the debt ratio, and decrease unemployment rates, which currently sits at 10.5% (and is a grotesquely high 32.5% for young professionals).[10] However, the EU Commission’s economic analyses suggest that this strategy will fail to produce the economic returns the Italian government expects and leave Italy with an even larger debt burden.[11] This would lead to further market turbulence, credit downgrades, and will severely restrict credit lines for Italian companies. Consequently, a failure to address these issues would have a widespread economic impact.

The Commission’s concerns are well-founded – decades of economic strain and inefficiency serve as proof that Italy is in poor financial health and ill-prepared to increase government spending. Italy’s €2.3 trillion in national debt is extremely risky, and budgetary issues have contributed in bringing its economy to the brink of recession.[12] The Commission says Italy’s budget plan would increase the structural debt-to-GDP deficit by around 1.2% of GDP, or about €22 billion, and is demanding a deficit reduction instead.[13] That would imply spending cuts far in excess of the roughly €8 billion of savings that Italy’s government currently plans.[14] With its outstanding debt obligations, Italy has many worried that it could default on its debt, triggering a recession and greatly weakening the Eurozone.

As of recent, the European Central Bank and other foreign creditors have ceased purchasing Italian government bonds and debt, because they question Italy’s ability to pay off its debt obligations, especially with concerns that the proposed budget will continue to raise interest rates and lead to the government defaulting on its debt.[15] There is fear that these government bonds, whose yield rates have reached record highs, will become worthless.[16] At the moment, Italian banks, who are the primary holders of these bonds, would also incur tremendous losses on these sunk assets. Devoid of billions of euros in assets, the banks would be forced to open new lines of credit that would make them susceptible to defaulting on their own debt obligations. In this potential scenario, the banks would be dependent on its bankrupt government to bail them out, likely forcing extensive stimulus packages and loans from the EU and thereby weakening the Eurozone. Furthermore, even these last resort stimulus packages are not guaranteed. If the European Central Bank (ECB) and other international creditor refused to lend to Italy’s government to keep its public services running, the political and economic consequences would be incalculable.

The fiscal tension resulting from MS5’s policies has also greatly impacted interest rates, bank loans and growth in the Italian private sector, creating a trickle-down effect of negative repercussions. Interest rates sit at all-time lows; however, the Italian banks are skeptical of a financial downturn and an increase in loan defaults, and have greatly reduced the number of loans available to the public.[17] In Italy, 90% of small and medium sized businesses are dependent on bank loans, but even the safest borrowers have suffered a reduction in the availability of these loans.[18] As a result, Italy’s business activities and entrepreneurial ventures have all been curtailed. The IMF estimates that the credit tightening triggered by Italy’s budget plan has already slowed economic growth and that this decline cannot be reversed by Italian stimulus spending.[19] In addition, an economic tool, the Purchasing Managers Index (PMI), indicates that Italian business activity contracted in November, raising the likelihood that Italy is moving towards recession. Italy’s GDP fell by 0.5% in the third quarter, which many attribute to a steep decline in business investments, compounded by hesitant consumer spending.[20] Finally, the PMI predicts that Italy’s economy will contract once more in fourth quarter, meaning the country will enter a technical recession for the first time since 2013.[21] Italy’s GDP has consistently grown at rates lower than the whole of the EU since 2012, but its decline in the last quarter has made it apparent that fears over the new budget are well-founded. The resulting contractionary financial spending by Italian banks has already hurt Italian businesses and under the proposed budget, these issues will only be exacerbated in the private sector.

The growing risk of recession is putting pressure on Italy’s new government to yield to the EU Commission and comply with EU fiscal rules, despite MS5 and the League’s previous protests. As of December 2018, Italian Economic Minister Giovanni Tria has suggested that he is willing to start a dialogue with the Commission to adjust MS5’s proposed budget, yet he also maintains that any such changes should not impede economic growth. If economic growth is Italy’s key priority, then MS5’s course of action is obvious – it must fully comply with the EU Commission. The confidence shock to bond markets, Italian banks and the country’s business sector illustrates the constraints facing financially fragile nations like Italy in the Eurozone. The current economic troubles are felt by everyone from the government to the banks to the Italian workers. In the long-run, to ensure the strength of its currency and access to ECB funds, the Italians are best-served by remaining in the EU. In the interim, to revitalize its economy, its businesses, and create job growth, Italy must cooperate with the EU to prevent the country from encountering the same economic conundrum that Greece currently faces. While it might not serve their political interests, the Italian government must accept EU demands to keep itself from pushing its own economy into a recession.

The uphill battle to fix the Italian economy will require greater political compliance by its ruling government, who may have to sacrifice its campaign promises for the betterment of its country’s financial health. Although it is unrealistic to expect that the Italian economy will recover in the immediate future, heavy changes to MS5’s proposed budget are necessary to keep the economy from sliding into a recession with Eurozone-wide consequences. In any case, it is certain that economists, international investors, and Italian citizens will be closely watching the ongoing dialogue between Italy and the EU Commission. With Italy on the verge of a recession, it is imperative that they heed the EU’s concerns and adjust their budget to prevent the collapse of their economy.  

Endnotes

[1] James Politi, “Populist Beliefs: Where Italy’s League and Five Star Stand,” Financial Times, May 10, 2018, https://www.ft.com/content/8ca9a840-543e-11e8-b3ee-41e0209208ec.

[2] The Associated Press, “Italy’s New Populist Leaders Vow to Deliver on Campaign Promises,” The New York Times, June 08, 2018, https://www.nytimes.com/2018/06/03/world/europe/italy-government.html.

[3] The Associated Press, “Italy’s New Populist Leaders Vow to Deliver on Campaign Promises.”

[4] Bjarke Smith-Meyer and Silvia Sciorilli Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans,” POLITICO, November 24, 2018, https://www.politico.eu/pro/commission-calls-for-disciplinary-action-against-italy-over-budget-plans/.

[5] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[6] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[7] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[8] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[9] Jan Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant,” Reuters, November 21, 2018, https://www.reuters.com/article/us-italy-budget-eu/eu-moves-to-discipline-italy-over-budget-rome-remains-defiant-idUSKCN1NP2MX.

[10] Eric Sylvers, “Italy’s Big Budget, Designed to Help Business, Is Hurting It,” The Wall Street Journal, November 21, 2018, https://www.wsj.com/articles/italys-big-budget-designed-to-help-business-is-hurting-it-1542796201.

[11] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[12] Giovanni Legorano and Paul Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession,” The Wall Street Journal, December 05, 2018, https://www.wsj.com/articles/italy-tries-to-end-budget-fight-with-eu-as-economy-teeters-on-recession-1544017194.

[13] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[14] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[15] Sean O’Grady, “Italy Is Pushing Europe to the Brink of Another Economic Crisis,” The Independent, October 03, 2018, https://www.independent.co.uk/voices/europe-italy-eurozone-debt-crisis-salvini-on-the-brink-economic-crisis-not-new-a8566416.html.

[16] O’Grady, “Italy Is Pushing Europe to the Brink of Another Economic Crisis.”

[17] Jason Horowitz and Steven Erlanger, “E.U. Rejects Italy’s Budget, and Populists Dig In,” The New York Times, October 23, 2018, https://www.nytimes.com/2018/10/23/world/europe/italy-budget-eu.html.

[18] Horowitz and Erlanger, “E.U. Rejects Italy’s Budget, and Populists Dig In.”

[19] Legorano and Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession.”

[20] Joseph Hayes, “PMI Suggests Italy to Enter Technical Recession in Fourth Quarter,” IHS Markit, December 07, 2018, https://ihsmarkit.com/research-analysis/pmi-suggests-italy-to-enter-technical-recession-in-Q4-071218.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed: MarkitPMIsAndEconomicData.

[21] Hayes, “PMI Suggests Italy to Enter Technical Recession in Fourth Quarter.”

[22] Legorano and Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession.”