Italy plays for high stakes in its fiscal poker game
The country’s debt sustainability remains on a knife edge
The past few weeks have provided global investors with a riveting game of what I like to call “Italian hold ’em”. Italy’s coalition government has been playing poker with the public, the EU and the markets as it cobbles together its fiscal and economic projections ahead of Thursday’s budget announcement.
The public started the game of poker by drawing a new hand in March, rejecting traditional centrist parties and voting for the populist League and Five Star Movement. The coalition government formed by the two parties has largely bluffed its way through the game so far. It has pledged both that its fiscal plans for 2019 will not make the structural budget deficit worse than in 2018, and that it does not feel constrained by Europe’s fiscal rules.
Yet the League and Five Star came to power promising to implement a universal basic income and flat tax, roll back previous pension reforms and scrap a planned value added tax rise. Following the fatal collapse of a bridge in Genoa, the government has also championed infrastructure spending.
This all costs money, which is problematic for the eurozone’s second-most indebted country (behind Greece). While finance minister Giovanni Tria has suggested some savings could be generated by reducing tax breaks and deductions, that is unlikely to fully offset the government’s expansionary priorities.
The markets and the EU are both calling the government’s bluff. Yields on Italian government bonds have risen on the back of government promises to spend and fallen following reassurances from Mr Tria that the 2019 deficit would be lower than feared.
By the end of the year, Italy will have missed its fiscal targets in 2017 and 2018, which raises the possibility that it will be placed in the EU’s “excessive deficit procedure”, a sort of budgetary timeout that could result in sanctions. This would not be a disaster — sanctions have never been applied — but it would leave the European Commission with limited appetite for allowing Italy more fiscal room for manoeuvre.
The Italian government cannot fold to pressure from the markets and the EU for fear of losing the pot to the public, and with it its popularity. And it cannot raise (the deficit) or it loses the pot to the markets and the EU.
Game theory suggests a fudge. To avoid losing the poker game, the Italian government must offer at least some plan to meet its electoral pledges while reducing the deficit moderately, even if less than the EU would like.
But even if Italy wins this hand, it may not win the game. Whatever its fiscal and growth projections, there is no guarantee they can be achieved. Italy’s debt burden is sufficiently high, and investor confidence sufficiently skittish, to put its debt sustainability on a knife edge.
Second, even if Italy’s medium-term fiscal plans are reasonable, they could be knocked off kilter by global developments. Most economists agree that as fiscal stimulus measures peter out in the US, the risk of an American recession will rise significantly from 2020. That could damp growth in the eurozone, just as Italy’s debt obligations are at their highest.
Third, Italian banks remain fragile and continue to be the country’s Achilles heel. And finally, there is no credible plan for what to do if Italy were to get into trouble.
European Central Bank officials have waved off such concerns, claiming Italy will just ask for an Outright Monetary Transactions programme if necessary — a bailout that comes with strict conditions.
My fear is that no Italian government would be willing to accept the strict conditions attached to an OMT, least of all a populist one.
All of which makes the stakes in this poker game rather high as Italy prepares to up the fiscal ante this week.