Skyline of Florence, Italy

Italy Politics March 2018

Italy: Elections jeopardize outlook for economic reforms

Italy’s government is locked in a political stalemate after elections on 4 March delivered a hung parliament. No party or coalition won an absolute majority, and anti-establishment parties gained over half of parliamentary seats. The center-right coalition—formed by the League, Silvio Berlusconi’s Forza Italia and Brothers of Italy—won the most votes and seats, followed by the statist, anti-establishment 5 Star Movement (M5S) and at a good distance by the ruling Democratic Party (PD), which suffered a significant outflow of votes. Italy faces a period of prolonged political uncertainty, which could jeopardize policymaking and ultimately result in snap elections. Without the necessary reforms, the economy will likely continue growing at a mediocre rate. Moreover, the election results entail downside risks for the fiscal deficit and the sustainability of public debt, as the formation of an anti-austerity, Eurosceptic government is a possibility.

Given the uncertainty, it is now difficult to say which outcome is most likely. Any prospective government will have to count on the support of forces that campaigned on increasing government spending or lavish tax cuts, which could lead to tensions with the EU over fiscal responsibility. A government led by the M5S party and supported by the Democratic Party or the League could damage future economic growth and the sustainability of public finances, especially if M5S follows through with its more radical proposals, such as a universal basic income and canceling the labor market reform.

A center-right government could boost the economy in the short term by cutting taxes on personal and corporate incomes. However, the fiscal deficit would likely grow, as the League has already stated that it would not necessarily respect the EU’s 3.0% deficit-to-GDP ratio rule. Lastly, the possibility of early elections at the end of this year cannot be ruled out. A return to the polls after a period overseen by a caretaker government would mean no public spending increase or economic reforms. The economy would likely continue growing at its current sluggish pace.

Half of voters chose anti-establishment parties M5S and the League, so a government could not be formed without one of them. The center-right coalition won the most votes and seats. Although the Democratic Party lost over half its seats, it could now hold a kingmaker position in the formation of the new government. The results show a divided Italy: In the North the center-right coalition won the most votes with promises of lower taxes and a tightening of immigration laws, while in the South the M5S came out on top with a statist and populist platform. Since these two parties represent very different interests and areas of the country, it is difficult for them to agree on common policies, apart from the questioning of European budgetary constraints and the need to regain full control on budgetary and immigration policies.

Commenting on the most likely scenarios, in a recent article entitled “Italy shoots itself (and the euro area) in the foot”, Lieven Noppe, Senior Economist at KBC, stated that:

“The results of the recent Italian elections render further economic reforms all but impossible. In voting as they did, the Italians have shot themselves in the foot, as their future prosperity is now in jeopardy. And without structural economic improvement, Italy also continues to pose a latent threat to the euro area.”

The election results mean that bold reforms are unlikely to materialize, and Italy’s growth potential and outlook will likely remain below that of its European peers. However, the recovery is expected to continue this year, albeit at a sluggish pace. Fixed investment should expand on favorable financing conditions and an improved fiscal framework. Moreover, declining unemployment and low inflation should underpin household spending. That said, sustained political uncertainty could eventually translate into heightened financial instability.

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