Italy's budget issues: A problem of the EU's own making

Italy’s populist government has upset the European Commission with the release of its budget plans for the next three years, and the IMF has now got in on the act by warning that they risk upsetting markets. The whole furore is based on the fact that the current budget plans are higher than those outlined by the previous government. But by continuing to criticise the Italian government’s plans in public, the EC risks the very thing it is concerned about by driving bond yields higher, thereby raising debt servicing costs and exacerbating the debt problem. Whilst the EC’s criticisms of the Italian budget targets may have some validity, the fact is that EMU fiscal procedures are not fit for purpose – and perhaps never were.

To put it into perspective, the previous government targeted a deficit ratio of 1.6% of GDP which the EC deemed acceptable in order to help keep Italy’s high debt-to-GDP ratio in check. But the new government, a coalition between M5S and the League, pushed for a much higher deficit in order to fund some of its more populist schemes. Finance Minister Giovanni Tria, who is not a member of either party, initially tried to hold to the previous government’s plans but appears to have lost the domestic political battle. In late September, the budget plan envisaged a deficit-to-GDP ratio of 2.4% of GDP for the next three years but following concerns that this was too high, and despite claims by the Deputy Prime Minister that “we will not backtrack by a millimetre”, the government is now targeting deficit ratios of 2.4%, 2.2% and 2% in 2019, 2020 and 2021 respectively. 

Strictly speaking this is not an excessive deficit, which is broadly defined as 3% of GDP, and is the benchmark against which the Italian government judges its plans. But the EC’s fiscal rules are a lot more complex than they were prior to the financial crisis and it is the devil in the detail that has resulted in Rome and Brussels having very different opinions regarding the budget plans. In 2011, the EC introduced a series of reforms known as the “six pack”, one of which is designed to limit the growth rate of government spending to no more than the medium-term potential GDP growth rate. In addition, governments are now subject to Medium-Term Budgetary Objectives (MTOs), which in Italy’s case requires it to reduce the structural budget deficit to zero.

Of course the reason that the EC is so concerned about the Italian fiscal position is that it has very high debt levels (131.8% of GDP in 2017 versus a Maastricht Treaty reference value of 60%). But Italy has never even come close to meeting this threshold and was allowed into the single currency area despite a debt ratio that was way out of line with the entry requirements. Indeed, in November 2003 I wrote the following:

It is now far too late to impose on Italy the kind of fiscal austerity required to get the debt ratio down. The damage was done twenty years ago.

Italy’s problem now is that the EC’s concerns have spooked the markets and forced 10-year bond yields to their highest since early 2014 which will further raise budgetary pressures. Technically, the EC’s fiscal rules allow it to levy fines on Italy for failing to comply with its MTOs, which would be to add insult to injury. But this would be inadvisable. For one thing, Italy’s proposed 2.4% deficit ratio next year is below that of France (2.8%). Moreover, Italy is a net contributor to the EU budget to the tune of around 0.2% of GDP. And it is also the world’s third largest bond market. 

Unlike Greece, Italy will not be so easy to push around. The EC can huff and puff as much as it wishes but there are limits as to how much leverage it can exert if the Italian government is not prepared to cooperate. Perhaps more importantly, the very fact the EC is still talking about austerity after a decade of hard economic slog suggests there is a lot wrong with the rules. In any case, a couple of tenths on the deficit ratio does not mean much when the debt ratio is above 130%. By making an issue of it the EC risks exacerbating the problem, prompting a market reassessment of the whole euro zone bond sector, especially in view of the imminent end to ECB purchases. And as a final thought, two-thirds of Italy’s €2.3 trillion of outstanding debt is held by domestic residents (the ECB holds around 15%). Somehow, I can’t see the prospect of higher returns on these holdings being a great problem for yield-starved domestic investors.