Italy Limbers Up for Its Next Big Fight With Brussels

(Bloomberg Opinion) -- If you thought the fight between Italy and the European Commission was over, think again.

This week, Brussels produced its latest batch of forecasts for EU countries. For Rome, they paint an ugly picture. Italy is expected to grow by a meager 0.1% this year, the slowest pace in the bloc. Meanwhile, its budget deficit is forecast to reach 2.5% of gross domestic product in 2019 and 3.5% in 2020. Government debt will also increase, topping 135% of GDP in 2020.

The Commission’s estimates are subject to mistake, as is the case with any forecast. Italy had a decent first quarter, and the improving outlook in Germany may offer an extra boost. But unless economic conditions brighten considerably for the Italians, policymakers in Brussels will soon face a conundrum: Should they reopen the confrontation with the country’s populist rulers over their fiscal targets, or stay quiet because of fears that this will just provoke another backlash against “eurocrats”?

In a sense, the Commission has itself to blame for this dilemma. At the end of last year, it chose to compromise with Rome over its 2019 budget, even though it was clear that the Five Star-League coalition government would never meet its proposed targets. The Commission and the Italians settled for a 2% budget deficit, as Rome set aside another 2 billion euros ($2.2 billion) in possible spending cuts, to roll out just in case.

Brussels now forecasts that Italy will miss this objective; the country may even go above the original 2.4% deficit target that the Commission rejected originally. Worse, Rome is on course to let its budget deficit go above 3% next year. While the finance ministry has earmarked VAT increases worth more than 20 billion euros to bring the deficit back under control, the Commission isn’t factoring for this in its estimates – and with good reason. The leaders of Five Star and the League have said repeatedly that VAT won’t go up, regardless of what their finance minister might think.

For the past six months, the Dutch government has complained loudly that the Commission has been too lenient with Italy. While true, the alternative might have not been much better. The EU economy has slowed and an overly stringent budget may have done more harm than good to the country’s finances. Still, Brussels must now decide how – and when – to deal with Rome’s constant breaking of promises. It could demand additional measures as soon as next month, or wait until the autumn for the next confrontation.

It doesn’t help that the political landscape is shifting, both in Italy and in the rest of the EU. At the end of May, there are elections for the European Parliament, which will pave the way for a new European Commission to take office in November. It will be difficult for Jean-Claude Juncker’s administration to do battle with member states in the meantime, given that everyone knows it will soon be replaced.

Much will depend on the makeup of the new European Parliament. With populist parties expected to prosper in the election, Luigi Di Maio and Matteo Salvini, the Five Star and League leaders, are betting that the next batch of lawmakers will be more forgiving of Italy. But with the national interest increasingly taking precedence in the EU over supporting your neighbors, they may get an unpleasant surprise.

The political outlook in Italy is no clearer. Five Star and the League bicker constantly. Salvini’s party is expected to do much better than Di Maio’s in the European election, even though the League is the junior partner in the governing coalition. This reversal of fortunes will add to the tension, as Salvini is certain to demand more say over the government. Whether or not the coalition survives the European election could well depend on whether the League’s leader feels confident enough to collapse the government in the expectation that he would win big in a fresh national vote.

So it’s hard to guess the timing of Brussels’s and Rome’s next clash. But clash again they will. The trouble isn’t so much that Italy decided to stimulate its economy somewhat this year, but that it did so in the worst possible way. For example, it lowered its pension age temporarily, which will increase spending without providing any meaningful boost to growth. What’s more, there is no credible path for the budget deficit to return toward balance, which is why public debt shows no sign of falling in relation to GDP.

This cloud of uncertainty will do little to foster investment in the country. The sovereign bond market is calmer than it was at the end of 2018, but yields are still well above other southern European countries, including Spain and Portugal. The Commission expects investment in Italy to shrink in 2019, making it unique in the euro zone.

The sad reality is that the political drama between Brussels and Rome is only a sideshow. Italy’s future depends ultimately on its economy. And that looks precarious.

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.

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