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Saturday 16 November 2019

Italy's EU game of budget chicken gets serious

Italy's populist government is pushing to run a higher budget deficit in 2019 and the EU core is unamused

Stand-off: Matteo Salvini, Italy's interior Minister, has doubled down on budget plans this week despite the EU's reaction
Stand-off: Matteo Salvini, Italy's interior Minister, has doubled down on budget plans this week despite the EU's reaction

For a long time, Italy has been Europe's hidden crisis. Now, though, it's becoming much more open.

The problem is simple: Italy's economy has forgotten how to grow. Even if you cast things in the most favourable light possible by adjusting for its shrinking working-age population, Italy's economy is still roughly the same size today as it was in 2003. Which, together with the legacy of all the red ink it ran up in the 1980s, means that it's had to run persistent primary budget surpluses just to keep its debt burden from spiralling up even more.

This combination of non-existent growth and all-too-real austerity seemed like it would inevitably lead to a political backlash, which, right on cue, it did earlier this year. The vaguely left-wing Five Star Movement captured the country's poverty-stricken South with its plan for a basic income for the needy, while the stridently right-wing party The League won in the more prosperous North with its promise to cut taxes and kick out immigrants. Together, then, they've formed a government of one-time outsiders whose slightly less restrictive budget looks like at least a minor repudiation of Europe's reigning fiscal orthodoxy.

How is this a crisis then? The answer is that Europe isn't treating this like a relatively small-bore disagreement - Italy's populist government, after all, is only proposing to increase its 2019 deficit from 0.8pc to 2.4pc of GDP - but rather as a direct challenge to the "ever-closer-union" they're trying to create.

It's one thing, you see, to run a bigger deficit, like France will next year, when you're apologetic about it and are ruled by the very avatar of Europhilism that is French President Emmanuel Macron. But it's quite another when you seem to be making a point of flouting the rules, and don't seem all that committed to the idea of the European project. And so the European Commission, the supranational body that has the authority to reject any country's budget, has signalled that it might take the unprecedented step of doing so if Rome doesn't show more obeisance for the deficit rules they all agreed as part of Europe's Fiscal Compact.

That, in turn, has been enough to send Italy's borrowing costs creeping back up to levels that, while still far below the ones that threatened to push it out of the eurozone in 2011, are still uncomfortably above the completely benign ones that prevailed as recently as 2016. Even more ominous than that, though, is that this has made the gap between Italy's 10-year borrowing costs and Germany's jump back up to levels last seen in 2013. Markets are beginning to worry that Italy's debt is riskier than everyone else's.

It's worth thinking about why that is exactly. It isn't that bond investors are nervous about Rome's budget plans themselves. It's that markets are worried about Europe's reaction to Rome's budget plans.

The simple story is that Italy's economy is only as stable as the European Central Bank allows it to be. There are a few reasons for this. The first is that eurozone countries can be vulnerable to self-fulfilling panic where their borrowing costs go up because it looks like they might default, and it looks like they might default because their borrowing costs have gone up so much. This is, in fact, what nearly brought the common currency down in 2012. And the only way to stop it from happening is for the European Central Bank to say it won't let it. This hasn't been an issue in the last few years because the ECB has already been buying bonds in an effort to stimulate a stronger European-wide recovery. But it could be one soon, since that bond buying is scheduled to come to a close at the end of the year. At that point, the ECB would require Italy to adopt a new austerity budget to get any help - which probably wouldn't happen considering that that's the very thing it's trying not to do. It's no wonder, then, that markets are betting the ECB will let Italy's borrowing costs keep going up.

What makes this a game of chicken and not just a one-sided threat is that an Italian default and exit from the euro would immediately put other countries under pressure as well. The idea being that if it could happen to one of them, it could happen to any of them. It's a theatre of the absurd: 60 years of integration being held hostage by a few decimal points worth of deficit spending.

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