(Bloomberg) -- In a move that doubtless prompted relief across Europe, Italy's populist about-to-be government made clear that it is not now looking for the European Central Bank to write down 250 billion euros ($295 billion) of Italian sovereign debt. At least that was the reassuring message to markets from the latest set of meetings between leaders of the Five Star Movement and the League. But the populists do, reportedly, want all of the sovereign bonds held by the central bank as part of the ECB's bond-buying program to be magicked away in official assessments of Italy's public debt.
This second proposal will sound less alarming to most observers. Alas, it suggests that the people who would like to run the next Italian government do not know the difference between a stock and a flow.
The latest forecasts from the International Monetary Fund see Italy's debt ratio falling from just over 130 percent of gross domestic product in 2017 to about 110 percent by 2026, but only with much tighter policy than has previously been achieved. The primary budget surplus — the excess of revenue over noninterest spending — is supposed to rise from 1.7 percent of GDP to 3.6 percent over the next few years, then stay at that level indefinitely.
Those forecasts looked unrealistic, long before the election. For reference, there is currently no advanced economy with a primary surplus of 3.6 percent of GDP. But if you decide not to count the roughly 360 billion euros of debt related to quantitative easing held by the Bank of Italy, you get the same 20 percentage point drop in the debt ratio, today, without the fiscal heavy lifting. What's not to like?
The trouble, of course, is that the sustainability of a given stock of debt depends not on the "official" ratio but on the annual cost of financing it. If the government plans to keep paying interest on all of the debt, the basic strains on the budget will remain. If it's not planning to pay interest on the QE-related debt, then that's not so different from debt restructuring after all.
Bloomberg Economics forecasts from senior euro-zone economist David Powell paint a more realistic core scenario for Italy's public finances — one in which the debt broadly stabilizes as a share of GDP, rather than falling. Even a modest rise in borrowing costs or a slowdown in growth would set the ratio rising again.
If you factor in the extra borrowing implied by the other pledges in the draft coalition agreement, the line turns up very sharply indeed. It's the gradient of that future debt path that should matter to investors and to Italy's European partners, not the "official" assessment of the total stock.
I suspect the Italian party officials behind this proposal understand the arithmetic pretty well. They may also understand that, though Italy has been given a lot of leeway in its interpretation of European Union fiscal rules, fundamentally revising them is a nonstarter. What they may not sufficiently comprehend is how much this one proposal will embolden hardliners within the European Central Bank and the German government.
The Bundesbank and much of the German official establishment has been opposed to ECB bond purchases all along, precisely because they made life easier for indebted governments such as Italy's. They will certainly consider the advent of populists in Italy as all the more reason to oppose reforms that make risk-sharing in the euro zone more explicit.
As my colleague Ferdinando Giugliano has written, Italy voted for a different kind of government and deserves to get one. The fissures in the euro zone that Five Star and the League will further expose have been there for a long time and are not Italy's fault alone. They will not trigger another crisis overnight. But they have probably already dented French President Emanuel Macron's chances of advancing meaningful euro-zone reform at next month's EU Leaders' Summit.
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