Italy's Political Problems Could Wrack the EU

May 23, 2018 Topic: Security Region: Europe Tags: ItalyEUEuropeCrisisPoliticsRussiaImmigration

Italy's Political Problems Could Wrack the EU

Italy has the potential to be the next big crisis to face Europe—and its new leadership knows it.

Italy has finally formed a new government. The March 2018 elections left behind a radically different political landscape for Europe’s third largest economy, knocking out the pro-European center-left Democrats, with voters giving over 50 percent of their votes to two radically different parties, the Five Star Movement and League (and its allied parties). After over more than two months of negotiations, the duo have thrashed out their differences and agreed to form a government, taking Italy on a new path. Although there have been questions raised over the new alliance’s prime ministerial candidate, law professor Giuseppe Conte, the future direction of Italy—at least in the short term—will is the hands of the political outsiders.

The Five Star and League do not easily align to the traditional political divide of right and left; rather they are populist, anti-establishment, anti-European Union, pro-Russia, and favor the loosening of the country’s fiscal restraints to achieve a faster pace of growth. They are also anti-immigration, the League more so than the Five Star. There is an expectation that an early policy initiative will be to tighten immigration. And both parties have a sizable core who favor taking Italy out of the Eurozone and seeking forgiveness of a portion of the country’s public sector debt. Italy’s debt is equal to 132 percent of GDP and, as such, it is a drag on economic growth.

The probability of a Five Star-League government, with spending and tax cuts, as well as its stated rejection of EU budget rules has left European markets in a nervous condition and widened spreads between Italian and German sovereign bonds.

The pending new government’s views have also stirred up other European governments, which have little interest in reliving the financial turmoil sparked by the Greek sovereign debt crisis from 2009 to 2012. The French finance minister Bruno Le Maire was quick to warn his new colleagues in Italy, stating, “If the new government took the risk of not respecting its commitments on debt, the deficit and the cleanup of banks, the financial stability of the entire euro zone will be threatened.”

League leader Matteo Salvini promptly responded to the French finance minister, saying that the warning was “unacceptable” interference. He added, “I didn’t ask for votes . . . to continue on a path of poverty, precariousness and immigration: Italians first!”

According to Corriere della Sera, one of Italy’s leading newspapers, the cabinet-in-waiting is composed of Florence University law professor Giuseppe Conte as prime minister, with Five Star leader Luigi Di Maio serving as a joint minister of economic development and labor, while Salvini would be interior minister. Conte’s resume, however, has raised some questions about the validity of certain academic credentials, which could undermine his credibility and has complicated the transition process. Italy’s president, Sergio Matterella, has final say on the proposed new government and is taking his time.

Once in office, the first major challenge is going to be the economy. Italy’s next government inherits an economy that is finally growing. After an anemic 0.9 percent expansion in 2016, one of the slowest in Europe, the pace picked up in 2017 to 1.5 percent. According to the International Monetary Fund, real GDP growth is forecast to expand at 1.5 percent in 2018 and slow to 1.1 percent in 2019.

A key point of concern by the Five Star and League is that such weak growth rates do not bode well for reducing unemployment, which was declining but was still a high 11.3 percent in 2017. What makes this worse is that IMF projections through 2019 do not see Italian unemployment falling under 10.0 percent. Consequently, the pending new government will feel a high degree of pressure to take a different approach from tight fiscal policy, which means that it could find itself at odds with the European Union expects its members to have a fiscal deficit target of 3.0 percent and under. Italy’s fiscal deficit was 2.3 percent in 2017, under the EU target.

If the next Italian government opts to spend more, it could breach the target, which puts it in conflict with the EU. At the same time, if the fiscal deficit balloons out, then investor confidence could erode, which is not a positive development for a country with a total financing need equal to 22.2 percent of GDP in 2018 and 22.1 percent in 2019. And those IMF estimates are undertaken with the view that the country’s banks continue to function without another crisis.

The new Italian government is likely to test the current EU system. How it does this is important. If it takes an aggressive approach similar to that followed by the first Syriza government in Greece in 2015, Europe could be in for a bumpy ride. Greece’s prime minister, Alexis Tsipras, and his finance minister, Yanis Varoufakis, did much to upset what they perceived as the European establishment, led by the conservative Germans, whom they saw imposing heavy-handed austerity on Europe and their country in particular.

Greece’s confrontational strategy backfired into a test of wills with Germany, the world’s fourth largest economy. A country of eleven million people and a small economy (with a large debt), Greece was forced to make tough decisions ultimately swallowing tough austerity measures and structural adjustment in return for a massive bailout. In the case of Italy, however, change in EU policies could be pursued in a less sensational and acrimonious fashion by using its leverage as Europe’s largest debtor and third largest economy after Germany and France. In this case, size does matter.

And then there is the issue of whether a Five Star-League government will be able to remain united in governing Italy. The parties have a number of differences, with the Five Star being based in the south and central parts of Italy and the League in the north. Both parties are populist, but the league is more conservative and the Five Star is more leftist. Governing could be a real challenge and the new prime minister will have to work hard to find compromise in his cabinet’s policies.

Despite all of the complications facing the pending new government, the country’s mood is hopeful. A clear majority of Italians are supportive of the country’s promised new direction. According to Demos, a polling company, 60 percent of voters had a “favorable” or “very favorable” opinion of the Five Star-League coalition. The share of Italians who were “opposed” or “very opposed” to the new government accounted for only 34 percent. Along these lines, the new government believes that it has a popular mandate to enact change.

Italy has the potential to be the next big crisis to face Europe and its new leadership knows it. Consequently, while there may be a certain level of rhetoric out of the new administration, policy changes are likely to be gradual though heading away from EU policy guidelines. While this will be popular at home, it will cause a certain amount of worry in the rest of Europe. The real determiner for Italy is going to be access to markets. If Italian assets undergo a substantial depreciation and investor confidence erodes, then the government will have to take notice and rectify the situation. Playing chicken with the financial markets runs the risk of leaving Italy isolated and setting the stage for a larger European-wide financial crisis. Italy is too big to let fail, something of which Rome, Brussels and Berlin are keenly aware. Tough choices lie ahead for Italy’s new team and the rest of Europe. We wish them luck.

Scott B. MacDonald is a Senior Managing Director at KWR International. The views expressed here are his own and do not necessarily represent those of KWR International.

Image: The Italian Freccie Tricolori aerobatics team perform prior the start of the Italian F1 Grand Prix in Monza, northern Italy September 6, 2015. REUTERS/Giampiero Sposito