Italy Postpones Its Day of Reckoning

(Bloomberg Opinion) -- The Italian government has struck a deal with the European Commission over its spending plans for 2019. The agreement has won Rome a reprieve from the threat of sanctions and gave investors some festive cheer. But the accord won’t solve Italy’s deeper budgetary malaise, and may create additional political tensions.

Italy’s government has revised down its unrealistic growth forecasts and deficit target for 2019. The economy is now forecast to expand by 1 percent next year (instead of an overly optimistic 1.5 percent). Borrowing is expected to reach 2 percent of national income, instead of 2.4 per cent.

The government insists it will press on with two flagship policies: lowering the retirement age and an income support measure, even though it will now commit much less money to these programs than it initially hoped. To fund these measures – while at the same time cutting borrowing – it had to find more than 10 billion euros of additional revenue or savings. So Rome has taken an ax to public investment and tax incentives for companies. It also plans a digital levy.

The European Commission deemed these extra measures sufficient to avoid launching a so-called “excessive deficit procedure”, under which Italy could be fined as much as 0.5 percent of gross domestic product. Brussels warned it could still do that early in the new year if Italy’s parliament approves a budget that reneged on the agreement. It has also asked Rome to freeze 2 billion euros of spending to ensure the deficit stays on target if, for example, growth were to disappoint.

The cease-fire was sufficient for investors to celebrate: The yield on Italy’s 10-year bond fell by nearly 17 basis points, to 2.77 per cent, while the benchmark FTSE MIB Index climbed 1.59 percent on Wednesday.

So, is the Italian crisis over? Not at all. For a start, the budget will do nothing to revive Italy’s anemic growth. In fact, it may worsen it. The burden of the spending cuts and tax increases will fall squarely on the shoulder of Italy’s producers. Competitiveness will be further reduced to help a few hundred thousand baby boomers retire early. For months, the government has paid lip service to the need to boost public investment to drive economic growth. This effort too, has been hampered.

The country's fiscal problems, too, are set to continue. The government had to abandon the idea of an expansionary fiscal stance for next year, and settle for a zero structural adjustment. What will happen in coming years remains an open question: Italy has pledged to raise value-added tax significantly if it cannot find other savings to meet its deficit targets for 2020 and 2021. But these safeguards have been ignored in the past, so there is no reason to believe they will be enforced now. The risk is that the expensive giveaways from the government – especially the lower retirement age – will prove a ticking bomb in the public accounts. The day of reckoning may have merely been postponed.

The budget may also create some political troubles for the ruling 5 Star and League. The coalition has enjoyed high approval ratings so far. But the climbdown with the European Commission has already stirred doubts among many supporters who had hoped for a sizable fiscal stimulus and a more aggressive stance against Brussels. The new savings will also hit some companies hard, eating into the support for the League in Italy’s industrial heartlands.

The lack of a credible opposition means that the two ruling parties are safe, for now. But the balance of the coalition government is becoming harder to sustain. The League has made a big jump in the polls since the elections in March (up to about 33 percent from 17 percent), while the 5 Star Movement has steadily lost support.

As the money becomes scarce, political tensions between the two partners could increase. May's elections to the European Parliament will be an opportunity for each party to gauge their support. This could tempt the League to seek a new general election.

If the budget which the League and the 5 Star have just put together ignores Italy’s future, that’s because the two parties aren't looking to that horizon. Their eyes are set on the coming months, not years. Italy may have ducked a fight with the Commission; it hasn't arrested its decline.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials 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.

©2018 Bloomberg L.P.