(Bloomberg Opinion) -- Italy’s populist leaders have spent the best part of a year looking for the outside forces who were driving up the country’s cost of issuing public debt. The answer, it turns out, was closer to home.
This week the yield on Italy’s 10-year bonds fell below 2%, while the interest on two-year debt turned negative. The yield spread with Germany’s 10-year bunds is also shrinking fast, down to 220 basis points, the lowest in a year.
Matteo Salvini and Luigi Di Maio, the heads of Italy’s ruling Five Star and League parties, should certainly thank Mario Draghi. The European Central Bank president has opened the door to a new round of monetary stimulus, pushing down bond yields across the euro zone. But this doesn’t don’t explain why investors have lowered the risk premium they demand on Italy’s bonds compared to other sovereigns. For that you have to look to Rome and its decision to seek compromise with its European Union partners over Italy’s budget plans. Markets have rushed to celebrate the truce.
Last month the European Commission took the first step toward recommending that the EU’s leaders should sanction Italy for breaching the bloc’s debt limits in 2018. Giovanni Tria, Italy’s finance minister, had sent a feeble response initially in which he failed to describe in detail how Rome would tackle its mounting fiscal challenges. The Italians have now changed tack.
The Five Star-League coalition approved a fiscal adjustment this week worth 7.6 billion euros ($8.6 billion), which will bring Italy’s deficit target down from 2.4% of gross domestic product to 2%. This falls marginally short of what the Commission has demanded, but many investors bet it will be good enough for Brussels at least to postpone its decision on whether to punish the country until the end of the year. The Commission meets on Wednesday to decide whether to press ahead.
The package put together by Italy is a mixed bag. Part of it simply notes that more money is flowing into the government’s coffers thanks to the introduction of electronic invoicing, which appears to have curbed tax evasion. But the government has also cut the amount of money to be spent on its two flagship reforms: A lowering of the retirement age and an income support scheme (whose take-up has been lower than expected). This is all a long way from the confrontational rhetoric used by Di Maio and Salvini against Brussels for much of their first year in government.
It would be tempting to conclude that the populists are really all bark and very little bite on fiscal policy. After all, they had already climbed down at the end of last year when they resubmitted their budget to Brussels with a lower deficit target and a more realistic growth forecast. The League and Five Star may try to win elections with undeliverable promises, but when it comes to actual tax-and-spending decisions Italy will not put its debt sustainability at risk – at least that’s how the argument goes.
It remains to be seen whether the Commission will reprieve Italy. But even if it does, it’s a little presumptuous to believe that Salvini and Di Maio have suddenly transformed into committed realists. This theory will face its biggest test in the autumn, when Italy has to deliver its 2020 budget.
Rome has to find more than 20 billion euros ($22.6 billion) in savings to meet its deficit targets, or else increase VAT by the same amount. The League and Five Star have insisted that they won’t allow this VAT hike to happen. But with Salvini also touting income tax cuts worth 15 billion euros, it’s hard to see how the math will work without something giving way. Salvini’s income tax plan would bring the total amount of extra deficit in 2020 up to more than 40 billion euros. That’s a difficult place from which to seek compromise with Brussels.
If Salvini and Di Maio have learned anything from this week’s experience, they will start to prepare their ground for an honorable retreat in the autumn. By keeping their European partners and the financial markets onside, they would be able to keep enjoying low borrowing costs while concentrating on core political concerns (like immigration for the League).
Such a fiscal climbdown would be humiliating, though, especially for the Europe-baiting Salvini. So all options remain open, including a fresh election. Even if there is a truce with Europe, don’t expect it to last very long.
To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
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