Italy Has a Bigger Problem Than Nasty Letters From Brussels

(Bloomberg Opinion) -- Given the flurry of letters between the two sides, one might suspect some kind of close personal relationship involving Italy’s finance minister Giovanni Tria and the two European Commission officials in charge of economic and monetary affairs, Valdis Dombrovskis and Pierre Moscovici.

Unfortunately for Rome, you wouldn’t mistake the missives from Brussels as love letters. The latest correspondence notes that Italy’s public debt, among the highest in the euro zone in relation to gross domestic product, increased again last year. The Commission is mulling whether to impose a disciplinary procedure on Italy, which might lead to a financial penalty. Tria’s ministry is expected to respond on Friday.

I spoke with Tria at an event in Trento on Thursday, and he suggested he had no intention of passing an emergency budget, regardless of the threatening mail. He believes the country’s deficit this year will be below the government’s April forecast of 2.4% (the previous target was 2%). In a moment of general economic weakness, Italy cannot afford too sudden a fiscal correction, he said.

Tria is probably being too optimistic about this year’s fiscal outlook, which hinges on whether Italy’s GDP does better than the near-stagnation expected by most forecasters. But he’s right to say there’s no point in an emergency budget. The European economy is in a phase of uncertainty as the risk of a global trade war hits confidence and challenges German exports. Rushing through tightening measures may do more harm than good to the public accounts.

Still, the Brussels letter is the least of Italy’s concerns. The real problem is that the government is rapidly losing friends in the financial markets, pushing up its borrowing costs. Olivier Blanchard, a former economic counselor to the International Monetary Fund, said at the same event that he wouldn’t recommend too punishing a budgetary tightening for Italy. But he added that market credibility was crucial to ensuring that fiscal policy could be used effectively. Last year, Blanchard warned that Italy’s 2019 budget risked being a case of “contractionary fiscal expansion” (where higher interest rates outweigh any stimulus effect). That prediction is being borne out.

A priority for Italy must be to reduce the yield on its sovereign debt, which is alarmingly close to Greece’s. The responsibility belongs to the coalition government’s populist leaders; in particular, Matteo Salvini, head of the League.

Salvini triumphed in last week’s European Parliament elections, winning more than one-third of the national vote, and now he’s insisting he has a mandate to bust the EU fiscal rules. He wants to slash income taxes by introducing what he calls a “flat tax,” even though it isn’t clear where the money will come from. Rome has earmarked more than 20 billion euros ($22 billion) in spending cuts for next year, promising to hike VAT if it needs to hit the target by other means. But the coalition leaders have hinted repeatedly that these measures won’t happen in the end. This deprives Italy’s fiscal path of any credibility.

While Tria faces a very difficult balancing act between his populist masters and the markets, he’s not blameless. Over the past few weeks, he has returned to a theme that he explored in his former life as an academic: The possible financing by the European Central Bank of a limited Europe-wide investment plan. He acknowledges that European treaties prohibit this idea, but even airing it damages Italy’s credibility abroad. Investors could easily conclude that Rome isn’t serious about shrinking its deficit as it expects the ECB will solve its problems.

It’s hard to guess how long the coalition of the League and Five Star Movement will last. This week, the Five Star leader Luigi Di Maio survived an online vote after his party suffered humiliation in the European election. Salvini knows he has the upper hand in the government. He will push his favorite proposals, including tax cuts, and see whether Five Star prefers to stay in power or risk being defeated at a national election. This political backdrop only adds to Italy’s lack of stability.

For now, the demand for Italian debt remains solid, but the price the country is paying is high. As the global outlook over trade and the economy darkens, investors may demand even higher premiums on risky bonds. Italy doesn’t need a sudden fiscal contraction; it needs to give markets far more clarity about its future plans.

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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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