Which path for Italy? Portugal rather than Greece

In any European country whose public finances are fragile, a government elected on the promise of fiscal easing has every chance of finding its path blocked by the censors of Brussels and Berlin. This leaves two possibilities.

A headlong rush into the wall or the search for a compromise. The first strategy, tested in Greece under the calamitous tenure of former finance minister Yanis Varoufakis, was a failure. The second path, followed by the left-leaning coalition in Portugal, is a success. Italy has a high level of public debt but generates substantial primary budget surpluses. A budget crisis is not the baseline scenario.

There is no Italian Varoufakis

After two months of futile negotiations, and faced with the threat of the President of the Italian Republic, Sergio Mattarella, of appointing a “neutral” government until the holding of new parliamentary elections, the two main political forces, the League and the Five Star Movement (M5S), have finally decided to govern together. The government’s announcement is expected during the day. Fresh elections would not, moreover, necessarily have produced a different result from the previous vote on 4 March (table). At this stage, the M5S is Italy’s leading political party and the League is the dominant party in the right-leaning coalition which holds the most seats in the Parliament. By excluding each other, they failed to attain a majority. By entering an alliance, they represent 55% of the seats in the lower house and in the Senate.

In the past, these two political parties held vigorously hostile positions to Europe, seen as an incarnation of fiscal austerity deemed detrimental to economic activity and employment. A recurring promise was to organise a referendum to see whether Italy would remain in the EU and/or whether to keep the euro. After two decades of stagnation in per capita income, the Italians are, according to various opinion surveys, amongst the most hostile to the EU and the euro. Whilst severe criticism of Europe abounded during the electoral campaign– especially regarding the issue of migration– there is no longer any threat of an Itaxit referendum, neither amongst the leaders of the League, or those of M5S. There is no reason for the League-M5S government platform to resurrect this idea. This would be to run the risk of antagonising the European authorities, be it the European Commission tasked with monitoring member states’ budgets or the ECB, for which Italian securities account for 17% of its total sovereign debt purchases.

Italy is a country whose public finances are fragile and, in the near future, will be led by parties who have made electoral promises of a kind to deteriorate the fiscal position. The League and the M5S both want to call into question the pension reform adopted in 2011 by Mario Monti’s government under direct pressure from Brussels. The M5S is favourable to introducing a universal basic income. The League is favourable to introducing a flat tax on revenues and the creation of a kind of parallel currency guaranteed by future fiscal revenues. To further complicate the problem, the two parties will have to come up with additional revenues to avert a VAT rate hike in 2019. All told, all of the elements are in place for a lively confrontation between a country, which is favourable to an easing, and even a revision, of the budget rules, and Brussels, which must ensure these rules are applied, under the watchful eye of Berlin. This is not the first time that this situation has materialised. We have had two precedents in recent years: Portugal and Greece.

Before taking the comparison any further, here is a summary of the main metrics of the public finances of Greece, Portugal and Italy.

• These three countries have a high debt level, the ratio of public debt to GDP stands at 179% in Greece, 126% in Portugal, 132% in Italy (chart lhs).
• Over the last decade, the budget deficit exceeded 7% of GDP per annum in Greece and 6% in Portugal, whilst it was close to 3% in Italy. In 2017, the Italian deficit was 2.3%, i.e. well within the limits authorised by Brussels.
• Even at the height of the period of financial stress, between 2009 and 2013, Italy always generated a primary budget surplus (i.e., balance excluding interest charges) representing 0.9% of GDP on average. It is one of the few countries in the Eurozone to do so, together with Germany and Luxembourg. In 2017, its primary budget was 1.5% of GDP.

In the current configuration of GDP growth and financing rates, the solvency of the Italian debt has not been called into question. However, the issue could hinge on two conditions: on the one hand, in the event of another recession causing a cyclical deterioration in the public accounts and, on the other and in the more immediate term, if the markets begin to doubt, as was the case in 2011-2012, the integrity of the Eurozone and, more precisely, Italy’s continued presence within it, which would cause a surge in the risk premium demanded by investors. Note that even though the ECB has already largely rolled back its intervention on the debt market, before stopping completely in 2019, there has been no material effect on the Italian spread (chart rhs).

It is here that comparison with Greece and Portugal becomes more relevant:

• In January 2015, with Syriza’s accession to power in Greece, the government thought that it would be able to impose its views on the rest of Europe, using a mixture of audacity, insult and provocation. However, within six months, Greece was on the verge of expulsion from the Eurozone, thus forcing Prime Minister Alèxis Tsipras into a complete U-turn. The finance minister at the time, Yanis Varoufakis, hugely miscalculated its negotiating powers with Brussels and Berlin. Greece, which had begun to get its head above water in 2014, was back in recession in 2015 and 2016. This delayed the country’s economic recovery by two years.
• In November 2015, a coalition between the socialists and the far-left parties acceded to power in Portugal with the clear aim of calling into question the policy of fiscal tightening. A number of measures were voted (minimum wage, working hours in the public sector) which leaned in this direction. Fine minds, such as Joseph Stiglitz, recommended that the country quit the Eurozone for its own good. Overall, the government nonetheless complied with the general recommendations from Brussels concerning the structural reforms aimed at increasing growth potential.

For any political leader, at least one that is not considering political suicide – which in no way appears to be the case for the ambitious leaders of the League and M5S – the choice is any easy one: Portugal rather than Greece. Moreover, in 2018, now that all European countries experience a recovery, there is a cyclical easing in the budget constraint. However, note that unlike Greece and Portugal, Italy is not a small country. Its public debt market is one of the largest in the world, after the US and Japan. Any potential financial problem in Italy would have a systemic dimension. We can be sure that a Ligue-M5S government platform would not be welcomed with open arms by the Commission, particularly the calling into question of the 2011 pension reforms, but unless the Italian Treasury were to adopt irresponsible measures – which would be against well-established traditions in Rome -, a compromise with Brussels on the fiscal issues is certainly not out of reach. It is perhaps on the issues surrounding immigration and security policies that the clash would be fiercer, but on the face of it this is not a major concern of the debt markets.

Bruno Cavalier – Chief Economist – Oddo BHF
Fabien Bossy – Economist – Oddo BHF