(Bloomberg) -- First came Brexit, then Donald Trump, and now the rebellion by angry voters has landed its biggest blow on continental Europe.
Italy, the most indebted member of the euro region to avoid a bailout during the European debt crisis, has succumbed to the forces of nationalism and protectionism that emerged over the past two years as the biggest threat to the political order.
Efforts to form a broad coalition to dilute the power of the anti-establishment Five Star Movement floundered this week and the party’s 31-year-old leader Luigi Di Maio spent Thursday morning drawing up plans for a governing alliance with fellow college dropout Matteo Salvini, 45, of the anti-immigrant League.
Important issues are still to be settled, not least who will be prime minister. Yet they are on track to make Italy the biggest country to install a populist government since it formed the precursor of the European Union with five other nations almost 70 years ago. While France, Germany and the Netherlands chose a different path in votes last year, Italy always remained a risk.
“Italy is a wake-up call that populism is alive and well,” said Federico Santi, a political analyst at Eurasia Group in London. “There was a big wave of optimism after the French election, but the truth is that the problem definitely hadn't gone away.”
Salvini and Di Maio are now taking till Monday to finish their plan to form a government in Rome.
They still have to reconcile the League’s promise of a flat tax at 15 percent for people and businesses, while Five Star has offered a citizens’ income to poorer Italians. Both want to scrap the pension reform that helped weather the debt crisis but upset many voters.
League lawmaker Guglielmo Picchi said he expects curbs on immigration, tax cuts and “a more assertive stand” towards the EU as his party’s key issues in talks with Five Star.
“The difficulty in the talks is not so much who does what, as agreeing on the priorities,” Picchi, 45, a former Barclays Capital investment banker, said in an interview. “We need to be careful about Five Star’s citizen's income, Italy can't just shower money on people.”
Italian bonds dropped. The spread between the country’s 10-year debt and benchmark German bunds widened by six basis points on Thursday to 138 points, the widest since March. The gap increased by 15 basis points in the past three sessions, its worst run since December.
Cutting taxes to stimulate growth is a risky endeavor for a country with Italy’s fragile finances. It wouldn’t take much of an uptick in borrowing costs, or of a slowdown in growth, for the country’s debt to begin spiraling again, says Stephanie Flanders, head of Bloomberg Economics.
Italy’s debt is still at least 30 percent bigger than its entire economy, the second-biggest in Europe after Greece, and the new government will be arriving in office with two sets of expensive promises to justify.
“Italy is not much further away from a debt crisis than it was five years ago,” Flanders said in research note. “The fastest road to another euro-zone crisis still runs through Rome.”
That said, Italian bonds are still short of the 213 basis-point premium over bunds in April last year, when Marine Le Pen threatened to pull off her own revolt in France. The spread is also narrower than the 187 basis points in December 2016 after Premier Matteo Renzi’s resignation fueled concerns that a snap election could bring Five Star to power.
In the euro region, Rome-born Mario Draghi is keeping a lid on bond yields with the European Central Bank’s quantitative easing policy. The economy is resurgent, with even the perennial laggard Italy enjoying its best growth in more than six years, despite some recent signs of weakness.
And Italy has also made progress in addressing the mountain of bad loans in its banking system since 2016.
Indeed, Italy’s political class has been wrestling for decades with the stagnant wages and hollowed out industries that have blighted workers across the developed world.
Successive leaders failed to convince voters that the European recipe of free markets and open borders can turn things around. A series of backroom political deals and a surge in immigration fueled the sense of anger in recent years.
The old order buckled at the March election. Renzi’s outgoing Democratic Party suffered its worst ever result. Silvio Berlusconi, 81, was eclipsed as leader of the center-right by the more hard-line League. Five Star became the single biggest party.
Momentum then built behind the two populist groups. With the threat of a repeat election ravaging his party, Berlusconi on Wednesday freed Salvini from his center-right obligations, paving the way for a Five Star-League alliance.
Five Star, though, is a different beast today from two years ago. Since assuming the leadership mantle from its founder, the comedian Beppe Grillo, Di Maio has sought to moderate the party’s policies and broaden its appeal. Most crucially, he’s dropped the pledge to hold a referendum on euro exit which made Le Pen’s campaign in France so potentially explosive.
How the EU reacts will be critical. It’s in the midst of divorce proceedings after Britain’s vote to leave in June 2016 and has been troubled by nationalist rogues in the east emboldened by the election of Trump as U.S. president five months later.
“They could get into trouble and there's no real plan with what to do with Italy at the European level if they do,” said Megan Greene, chief economist at Manulife Asset Management. “If we do see the Italian government really clash with Brussels we could see calls again that Italy would be better off outside the euro area.”
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