The recently minted Italian government has made headlines for its harder stance on migration issues – and its willingness to go toe to toe with the EU to fight for what it sees as a more equitable distribution of burden sharing when it comes to welcoming refugees. But it’s the underlying problems in the Italian economy that are more problematic. These are by no means new problems, but what’s changed is that an Italian government has come to power that is more Euroskeptic than any previous government. Now the government, an admittedly weak one in terms of domestic support, is in the process of drawing up its first budget – and in doing so, it may pose a fundamental challenge to the European Union.
Like previous Italian governments, the governing alliance between the Five Star Movement and the League wants more control over monetary policy and government spending so that Italy can address its chronically mediocre growth rates and its high stock of nonperforming loans. (We would be remiss if we did not note that the rate of NPLs has decreased from a high of 16.8 percent of total loans at the end of 2015, when we thought it might set off exactly the sort of crisis we are describing here, to 11.1 percent as of the first quarter of this year.) What sets the new government apart is its more populist tendencies, for lack of a better word. The Five Star Movement, the single-largest vote-getter as a party, campaigned on a promise of a universal monthly income of 780 euros ($910). The League, meanwhile, catapulted to power on its promises to address immigration issues. The tragic collapse of a bridge in Genoa is a ready-made populist platform for government spending to overhaul Italy’s literally crumbling infrastructure – and the government is already singing that tune as well.
Both of these issues bring Italy into conflict with Brussels. On immigration, the Italian government has already threatened to withhold its contribution to the EU’s annual budget or to veto the EU’s seven-year budget if the bloc cannot come up with a better plan to redistribute the burden of welcoming migrants to Europe. The EU has threatened sanctions in response. Italy is even flirting with making common cause with Hungary and other anti-immigration stalwarts should the EU not bend to Italy’s demands. The spending issue, however, is more serious. In order for the Italian government to come close to delivering on some of its campaign promises, it has to be able to spend money. But the EU has a rule that annual budget deficits for EU countries may not exceed 3 percent of gross domestic product. (This rule doesn’t apply to all member states equally – just ask France, whose budget deficit exceeded 3 percent for almost a decade.) The Italian government cannot possibly stay below that threshold and spend the way it wants to.
Italian Deputy Prime Minister Luigi Di Maio’s interview with il Fatto Quotidiano on Tuesday was the latest sign that Italy may be preparing to flout this EU regulation. Responding to a question about whether Italy would abide by EU regulations on budget deficits, Di Maio, the leader of the Five Star Movement, made it clear that the Italian government was considering ignoring them. A day earlier, an Italian Cabinet undersecretary also said a budget deficit of greater than 3 percent of GDP was on the table. Bloomberg reported on Tuesday that some estimates show the government going as high as 5 percent of GDP. This would abrogate previous EU-Italy understandings, which have the deficit falling to 0.8 percent in 2019 before reaching a balanced budget in 2020. Last month, the Italian government indicated it had raised its target to 1.4 percent in 2019, but in the weeks since, rumors of higher figures have persisted. (There should be clarity on what Italy will do by the end of September.)
Of course, the EU has a reason to fear irresponsible spending by the Italian government. It was just that kind of spending that got Greece into its predicament – and it is increasingly hard not to see the similarities between Greece and Italy. After all, Italy is sitting on a mountain of debt. Its debt as a percentage of GDP is 133 percent. In the EU, only Greece (180 percent) has more – and only Portugal (126 percent) and Belgium (106 percent) also sport figures over 100 percent. The major difference between Italy and these other European profligates is size: 133 percent of Italy’s GDP amounts to 2.3 trillion euros – almost double the next three debt offenders combined. The travails of Greece, which recently graduated from the EU’s austerity program and will remain a pauper for decades as it pays back its loans, nearly broke the European Union. The EU’s biggest fear of late has been that if Italy goes the way of Greece, it won’t be too big to fail – it’ll be too big to save.
That is, if Italy wants saving at all. Paolo Savona, who published a book on how Italy might go about exiting the EU, was considered too radical to be named economy minister – but he is still in the government as European affairs minister. Savona’s plan involved defaulting on some public debt, redenominating other public debt in a new currency and, most frightening to the EU, defaulting on official debt to the EU, including Italy’s Target2 balances, which give a sense of what’s at stake here. Target2 is a eurozone payment system, and Target2 balances account for the claims and liabilities of eurozone central banks. As of June 2018, Italy had a negative balance of 481 billion euros, 21 percent more than the next largest negative balance (which belongs to Spain). Germany, on the other hand, sports a positive balance of 976 billion euros, almost 30 percent of Germany’s GDP. No other country is even close to Germany in this regard. That is why even the threat of an Italian default sends the coldest shivers down Germany’s spine.
To be clear, this is far from the most likely scenario. The Italian government, stitched together of various parties with different political aims, will likely collapse if it tries to take too aggressive a stance against the EU. Some Five Star Movement lawmakers have already expressed frustration with the antics and attention-getting of Matteo Salvini, the leader of the League. And there is still significant support for the EU inside Italy – the latest polls reported by Reuters showed that 44 percent of Italians said the benefits of the EU outweighed the disadvantages, as opposed to 41 percent who felt the opposite – so there are limits to how far Rome can push. Instead, the most likely scenario is the most boring one: that Italy uses its leverage as the EU’s biggest debtor to secure adequate compromises from Brussels to save face at home. That will no doubt rankle other EU countries, but for Brussels, and particularly Germany, that will be a small price to pay. After all, many EU countries are already rankled, and a major Italian default crisis would inflict far more pain than making compromises with Rome.
Even so, the potential that Italy might go the way of Greece – and might not consent to suffer austerity if it came to that – cannot be dismissed. And that such a scenario is even plausible speaks to how precarious the current situation is. It is, for instance, not difficult to imagine Brussels taking a hard line on Italy’s desire to increase deficit spending and its demands on immigration policy. This could, in turn, spark a new wave of europskepticism in Italy, forcing the Italian government to follow through on its threats – or at least forcing the EU to cave on its demands in such dramatic fashion that it would undermine what’s left of Brussels’ credibility in the rest of the bloc. And that works only if it isn’t already too late to get Italy to put off the apocalypse.
It is not a stretch to say, then, that the next chapter in the EU’s history has begun. It opened with the formation of this Italian government in May, and it will reach a critical point when Italy unveils its budget in September. If Italy takes a hard line and its government can survive the resulting faceoff with the EU, it will put Brussels in a difficult position, one that could undermine the very fabric of the EU itself. That is a lot of “ifs,” but none of them is particularly outlandish, even if unlikely. In the meantime, Brussels must decide just how tough it means to get with Italy. If the EU gives in, its authority may be weakened. But if it tries to treat Italy the way it did Greece, there might not be much of an EU left to govern. It is those impending negotiations – not Brexit, or any others – that will shape the EU’s immediate future.