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The EU v Italy’s new government: which will blink first?

Populist parties’ ambitious fiscal plans have put them on a collision course with Brussels

The majority of Italians want two things: new political leadership and the euro. The question is whether they can have both.
The point about new leadership is uncontroversial. The country’s two ruling populist parties, the League and the Five Star Movement (M5S), together commanded 50% of the vote in the 4 March general election, and, as a result, have majorities in both houses of parliament. Their majorities may be slim, but the election, in which the main centre-right and centre-left parties eked out just 33%, was a resounding repudiation of the status quo.
The second point is less well known, but even less controversial: recent polls show that 60%-72% of Italians favour the euro. Some believe the single currency safeguards their savings, while others regard it as an emblem of Italy’s status as a founding member of the EU. But if motives differ, the balance of public opinion does not.
Bowing to this reality, the coalition partners have now dropped the idea of abandoning the euro, expunging the possibility from their “contract” and respective websites. Paolo Savona, a diehard opponent of the euro, has been denied the finance ministry. But Carlo Cottarelli, whose proposed appointment at the head of a technocratic government would have disenfranchised a majority of voters, has also been denied the reins of power. Appropriately, given the election result, Italians now have their populist government and their euro, too.
Keeping them will be another matter. If its initial measures fail to deliver economic growth, the new government will lose popular support. In desperation and anger, its leaders may then resort to even more extreme policies. Support for the euro will weaken as well, because the government and its backers will blame the EU and its most visible achievement, the euro, for frustrating their best-laid plans.
Indeed, it is not hard to imagine that if the coalition proceeds with its ambitious fiscal plans, instituting both a flat tax, as the League proposes, and a universal basic income (UBI), as M5S advocates, it could blow up the budget deficit. It would then be sanctioned by the European commission, deemed ineligible for financial support by the European Central Bank, and experience capital flight. Italy could quickly find itself out of the eurozone and ring-fenced by capital controls, regardless of whether the government intended this outcome.
In fact, the argument for a measured fiscal stimulus is sound – just not the kind of fiscal stimulus the League and M5S have in mind. An economy in Italy’s condition needs “two-handed policies”: supply-side reforms of labour and product markets to boost productivity and international competitiveness, accompanied by demand stimulus to prevent the uncertainties of reform and the surrounding political noise from depressing spending. Although Italy has a heavy debt burden, it also has a modicum of fiscal space, given low interest rates and a primary budget surplus.
But whether the government will use that space to get growth going again is very much in doubt. The League’s flat tax would benefit mainly the rich, who have a relatively low propensity to spend, and aggravate complaints about inequality. And, given its dire fiscal implications, M5S’s proposed UBI would trigger a sharp reaction by financial markets.
A better approach would be to cut payroll and social security taxes, thereby reducing the third-highest tax wedge in the OECD. This should appeal to M5S voters, who would see bigger pay packets. To the extent that the recipients spend the additional pay, the tax cuts will stimulate demand and growth.
But these are also supply-side-friendly reforms, because they reduce the cost of labour and, by getting people into employment, facilitate the transmission of productivity-enhancing skills. They should also appeal to the League, insofar as business owners who support party leader Matteo Salvini will benefit from declining costs and enhanced competitiveness.
Will the European commission permit the Italian government to exceed its mandated deficit target? The commission worries, as always, about setting a dangerous precedent. But it should realise that frustrating the new government at every turn could end up only making the Italian authorities more intransigent. If the alternative to a modestly larger budget deficit, coupled with supply-side reforms, is a let-it-rip budget, open conflict with the EU, and massive capital flight, then the commission would do well to think twice.
The view within EU institutions in Brussels is that, when sanctioned by the commission and by financial markets, Italy’s new government will change course, abandoning its fiscal ambitions to avoid catastrophe. But the view in Rome is that the new government has the voters behind it and that Italy is too big to fail, so it is the commission and the other member states that will blink.
In America, there is a name for this situation. It’s called a game of chicken: two cars hurtle toward each other at full speed; the driver who swerves first is the chicken. It is a game that does not always end well.

The Guardian

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