Rarely does Italian fiscal policy seriously worry foreign investors accustomed to successive crises, but the 2019 budget proposed by Rome’s new coalition government of the League (“Lega”) of right-wing parties and the populist Five Star Movement (5SM) is triggering bad reactions in bond and equity markets, even fears of a renewed Euro debt crisis. The sharp sell-off in European and U.S. equities during the week of October 8 was attributed in part to when Italy appeared to thumb its nose at basic EU austerity measures.

Rome’s fiscal defiance results from the 5SM-Lega parties winning a startling 68 percent of the vote in the March election, as angry Italian voters blamed the traditional centrist parties and the European Commission (EC) for a decade of stagnant economic growth. The two parties have long criticized the EC, the EU, and the Euro but disagree on basic economic and social objectives. It took long, contentious negotiations, but in May they agreed on a coalition government based on an expansionary budget that rejects previous governments’ austerity.

Italy announced its 2019 budget’s broad objectives on September 27, and submitted the details, with some revisions, to the EC on October 15. The Commission announced its negative verdict this morning. As a result, Rome will have to submit a revised budget within two weeks or face sanctions – a procedure never used before. The Italian budget as submitted aims to boost economic growth with populist measures, such as guaranteed basic income, lowering the pension age to 62, broad tax cuts, infrastructural spending, and reversal of pension and tax reforms

The EC criticized the initial budget for breaching EU fiscal rules and reversing progress made with austerity policies. EU commissioners informed Italian Finance Minister Giovanni Tria that the budget showed “significant deviation” from previously agreed objectives. Tria and Deputy Prime Minister Luigi Di Maio dismissed the criticism, and Matteo Salvini, the Lega’s fiercely anti-EU Interior Minister, accused the EC and EC President Jean-Claude Juncker of being “enemies” of Europe.

International investors share the Commission’s skepticism about the 5SM-Lega budget, worrying that bond market stresses could lead to another crisis of confidence in Euro Zone government debt and the private banking system. Because Italy’s debt mountain is so large and the leeway for policy adjustment so small, markets also worry that the European Stability Mechanism (ESM) and European Central Bank (ECB) would have difficulty coping with a new Euro debt crisis.[1] Global bond markets also worry about Italy.

If Rome insists on aggressive expansionary policies, despite EC objections, market reactions may worsen as they did when Greece defied EC fiscal guidance.

If Rome insists on aggressive expansionary policies, despite EC objections, market reactions may worsen as they did when Greece defied EC fiscal guidance. There are few valid comparisons between the two countries’ economies and fiscal situations, but the idea that Europe’s fourth-largest economy and one of the EU’s founding states could disregard sensible fiscal policies means the 5SM-Lega budget challenge could cause more market volatility late this year.

The fiscal battle between Brussels and Rome may also exacerbate anti-EU sentiment in countries with EU-defiant governments such as Hungary, Poland, and the Czech Republic – and even in the EU cornerstones of Germany and France where the political center of gravity appears to be tilting toward populism and nationalism. Moreover, the “Nordic Club” grows increasingly exasperated with “Club Med’s” reluctance to tighten its fiscal belt.

China may be an unexpected source of irritation in the Rome vs. Brussels fiscal battles. Michele Geraci, Under Secretary of the Ministry for Economic Development, told Bloomberg in early October that Italy may participate in China’s massive Belt and Road foreign investment program which aims to extend Beijing’s commercial, infrastructural, and financial influence across Asia and Europe. He said Chinese investment in Italian railways, airlines, and culture would be welcomed and stimulate the economy. Finance Minister Tria and Deputy PM Di Maio visited Beijing in August and September to discuss increased cooperation. An agreement formalizing Chinese investment in Italy is expected to be signed by yearend, despite German and French pressure on EU countries to curb Chinese investment in critical infrastructure and key companies.

If Italy’s anti-austerity budget and open door to Chinese investment trigger a showdown between the 5SM-Lega government and the Commission, there is not only the risk of a new Euro debt crisis: The dispute could encourage the nationalist, populist, xenophobic, and anti-EU movements, parties, and governments that have proliferated since the first Euro debt crisis, and which threaten the European Union

If Italy’s anti-austerity budget and open door to Chinese investment trigger a showdown between the 5SM-Lega government and the Commission, there is not only the risk of a new Euro debt crisis: The dispute could encourage the nationalist, populist, xenophobic, and anti-EU movements, parties, and governments that have proliferated since the first Euro debt crisis, and which threaten the European Union. One must hope that market pressures will help persuade both sides to compromise on a revised budget that could stimulate economic growth while reducing Italy’s deficit and debt.

Paul Horne retired as Managing Director and former chief international economist of Smith Barney/Citigroup in Paris and London after a career of 40 years in Europe. As an independent market economist focused on transatlantic economic, financial, and political relations, he divides his time between the U.S. and Paris. Contact: [email protected].

[1] The European Stability Mechanism (ESM) was established in Luxembourg on Sept. 27, 2012, in the midst of the Euro debt crisis, provides Euro Zone states in difficulty with access to financial assistance. The ESM has a maximum lending capacity of €500 billion.

Click here to see the original posting of this blog entry on The Bertelsmann Foundation, posted on October 23, 2018.