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Italy Politics June 2018

Italy: Following months of deadlock, Italy forms a new government but still faces many unknowns

Three months after the elections and following two failed attempts to form a government, on 6 June the Italian parliament finally ended the political impasse and voted for a government formed by the populist Five Star Movement (M5S) and right-wing League party. The deadlock was broken when the League accepted to replace their pick for Minister of Finance, Paolo Savona, who was vetoed by the president, with Giovanni Tria, a university professor with a less Eurosceptic profile. Financial markets reacted nervously, sending the 10-year bond yield above 3.0% in the days following the arrival of the new government, although yields declined thereafter.

The new coalition’s proposed economic program, based on an agreement reached in mid-May following complex negotiations, is protectionist and fiscally expansionary, including both tax cuts and higher spending. It has, however, vague details on how to provide adequate financing. The proposed measures, combined with Italy’s colossal public debt and already sizeable fiscal deficit, could cause severe financial distress, especially at a time when the European Central Bank is preparing to reduce its monetary stimulus. However, a large degree of uncertainty exists over the extent to which the coalition will be able to enact its program, due to the ideological and territorial differences between the two parties and their electorates.

The introduction of a proposed two-tier flat tax (at 15% and 20%) on personal and corporate income could help reduce the country’s heavy tax burden, improve competitiveness and boost both consumer and corporate spending; however, it could also jeopardize government revenues. The proposed guaranteed income, which would provide a minimum income of EUR 780 per month for a single household for a maximum of two years, along with changes to how the retirement age is determined, could increase already bulky public spending and dent labor market participation, which is already at one of the lowest rates in the European Union. In addition, a proposed new hourly minimum wage could raise labor costs for firms, hitting employment.

Relations with European institutions will, furthermore, likely become strained under the new government. The coalition program commits the future government to promoting an amendment to existing European treaties that would devolve to member states some of the competences currently held by European institutions. Moreover, it questions EU rules on the fiscal deficit and proposes to exclude investment expenditure from the calculation of the deficit. These proposals, if carried out, could lead Italy to clash with European institutions and other member countries, who are already worried by the possible spillovers from a future mismanagement of public finances by the Italian authorities. In addition, the new coalition controversially wants to lift sanctions on Russia, which were the result of an agreement reached at European level. Further tensions may arise from migration policy. Italy is calling for a revision of the Dublin Treaty and wants to establish more stringent requirements for the reception and expulsion of immigrants. However, an agreement will be difficult to reach, given the existing divisions among EU countries.

That said, there is considerable uncertainty over how long the government will last and how much of its platform will be implemented, as Erik Nielsen, Chief Economist at UniCredit, explains:

“There is a reason why Italy has been relatively slow to reform the economy to match globalization and broader technological developments during the last 20 years, namely that the Italian governance system was very much designed with multiple safeguards precisely to complicate anti-establishment radical policy measures. These safeguards are likely to also work to slow down more populist policy reforms. This includes a constitution, which outlaws referendums on international treaties and budget discipline (as well as curb any desire to limit the freedom of individual MPs), a two-chamber parliament with equal weight, and an Accountant General and a president with wide-reaching powers to veto legislation, which they find in breach of any of the rules.”

The new coalition is inheriting an economy in a tentative recovery, although the pace of growth appears to have softened in Q2, amid softer growth in the eurozone and weakening business conditions. Growth firmed up in 2017, underpinned by solid investment and export growth. However, Italy was still the EU’s growth laggard, and its economy continues to be burdened by long-standing structural problems: a rigid labor market, stagnant productivity, high taxes, a troubled banking sector, cumbersome bureaucracy and elevated public debt. If the new government’s promises are kept, and not backed by sound spending cuts, public finances will deteriorate significantly, which would jeopardize the country’s financial stability. Country risk would increase, and strained relations with the EU would pose a major challenge for European institutions. Financial volatility is likely to persist in the coming months.

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