Italy Is Stuck in a Bad Cop, Worse Cop Routine

(Bloomberg Opinion) -- Italy's political turmoil has ratcheted up a gear, and is starting to spread to bond markets across the southern edge of the euro zone. Don't expect politicians in Rome to hit the brakes any time soon.

On Thursday, the European Commission issued a sharp rebuke of Italy's budget, which targets a 2.4 percent deficit for next year. The Commission said Rome's plans for a fiscal expansion of close to 1 percent of gross domestic product, when the European Council had recommended a contraction, and the size of the deviation were “unprecedented” in the history of the stability and growth pact.

Unfortunately, the Commission has only limited tools to deal with such infringements. Brussels can open a so-called “excessive deficit procedure,” which could lead to a fine of as much as 0.5 percent of GDP. But these threats are unlikely to sway Italy's leaders. The League and the 5 Star Movement thrive in their fights with Brussels. Matteo Salvini, the League leader, went as far as saying on Thursday that he could run as a candidate for the euroskeptic alliance to replace Commission President Jean-Claude Juncker. He will not be deterred by a monetary sanction.

The real question for investors is whether the ruling coalition will survive this budget session. The League and 5 Star are openly fighting over a tax amnesty included in the initial draft of the budget. Luigi Di Maio, 5 Star leader, said that the measure went too far, letting applicants off the hook for charges such as money laundering. The League initially held its ground, but a cabinet meeting could take place on Saturday to iron out the disagreement. This will be the first major test of whether the coalition is destined to last.

The trouble is that Italy is trapped in a “bad cop, worse cop” dynamic in which neither Di Maio nor Salvini has any incentive to back down from their irresponsible budget. The first to do so would be immediately labeled as a slave to Brussels and the financial markets – and would pay a price politically. Of course, as bond yields continue to rise and the country's stock indexes fall, the pressure on the two allies will rise. But the game of chicken could last for a long time before someone finally backs down.

Even then, it’s not clear what could replace the current government, and for how long they would last. The polls are showing the first decline in support for the League and 5 Star, but the two parties each still command support from about 30 percent of voters. A new election might enable Salvini to lead a center-right alliance with Forza Italia and the Brothers of Italy to victory – but that’s unlikely to change his stance on Europe and the country's budget deficit.

So Italy’s crisis is here to stay. The rest of Europe will have to prepare for the fallout.

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.