Italy’s anti-establishment 5-Star Movement and the far-right League spent the weekend locked in talks to forge a common policy programme and called the head of state on Sunday to report on their progress towards naming a Prime Minister. The parties were adversaries before the March 4 General Election, which produced a hung parliament, but have been negotiating since Thursday to fuse their very different election platforms into a “contract” of mutually acceptable policy commitments.

The Italian coalition taking shape 10 weeks after March’s inconclusive vote has made economic promises that seem incompatible with Europe’s fiscal rules and will be hard, if not impossible, to keep. These include slashing taxes for companies and individuals, boosting welfare provision, cancelling a scheduled increase in sales tax and dismantling a 2011 pension reform which sharply raised the retirement age.

The marriage being sealed between the two parties was seen as an unlikely and worrying prospect by most analysts before the March 4 election ended in a hung parliament. What their policies have in common is that they are extremely expensive.

On the face of it their plans, which they say may also include a form of parallel currency, could push the budget deficit far above targets agreed with the EU, setting up a clash with the European Commission and Italy’s partners.

5-Star’s flagship policy of a universal income for the poor has been costed at around €17bn per year. The League’s hallmark scheme, a flat tax rate of 15% for companies and individuals, is estimated to reduce tax revenues by €80bn per year.

Scrapping the unpopular pension reform would cost €15bn, another €12.5bn is needed to head off the planned hike in sales tax, and the parties are also considering printing a new, special-purpose currency to pay off state debts to firms.

If implemented, it would be the biggest shake-up of the Italian economic system in modern times.

Some of the parties’ negotiators now suggest a more pragmatic approach will probably prevail, by implementing their pre-election proposals only partially and gradually. In the face of voter disappointment, each group will be able to say it was forced to compromise with its partner.

Even so, it is still unclear how all this will square with Italy’s commitments to reduce its budget deficit and its public debt, which at more than 130% of GDP, is the highest in the Eurozone after Greece. Growing signs of an economic slowdown will make the new government’s task even harder. Industrial output stagnated in the first quarter and business confidence fell in April to a 14-month low.

Before the election, 5-Star and the League both blamed the EU’s fiscal rules for Italy’s chronically weak growth and rising poverty, and promised to defy Brussels by spending more if they managed to enter government. They are now using less strident tones, and a 5-Star official said on Friday any plans to raise the budget deficit will first be discussed with Brussels in a “courteous” way.

The outgoing centre-left administration promised the fiscal deficit would fall this year to 1.6% of GDP from 2.4% in 2017, and then decline to 0.8% next year with a balanced budget in 2020. 5-Star leader Luigi Di Maio said just before the election he would hold the deficit at 1.5%, having previously pledged to raise it above the EU’s 3% ceiling to allow extra spending on public investments. His latest position is still not consistent with Italy’s commitment to balance its budget, and is also out of line with the more confrontational stance of the League. The League wants to raise the deficit to 2.8% this year and to 3.0% in 2020.

So far, market reaction has been muted in response to what some analysts described before the election as the “nightmare scenario” of a 5-Star/League government. The gap between Italian 10-year benchmark bond yields and the safer German equivalent hit its widest level in seven weeks last week on news that a deal was at hand, but it had narrowed again by Friday and at this stage shows no sign of getting out of control. However, that could change very quickly.

Alan McQuaid (14/5/18)
Economist