Yellow-Green Route for Italy: the Final Act?

The new course of policy might soon lead Italy into the precipice of insolvency, capital controls, and even the exit of the Euro area. A column by Fabrizio Zilibotti.

Fabrizio Zilibotti
«Italians have chosen, through the rules of democracy, to forget reason and put themselves in the hands of healers.»

On March 26, in a column published in Finanz und Wirtschaft, I wrote about the «curious incident» of markets keeping calm after the election outcome that consigned Italy to a populist majority. I argued that markets would stay quiet for as long as no perspective of a political government would emerge.

Punctually, as soon as such a perspective has materialized, financial markets have started showing signs of distress. Over the last month, the value of 5 Years Italian Sovereign CDS has increased by 130 percent, going from 88 in early May to a maximum value of 283 on May 30, to close the week at 207. The concern has also triggered a generalized increase in the volatility of financial markets.

Eventually, last Friday a new yellow-green coalition government involving the Five-Star Movement and the Northern League has been sworn in. I argued in my previous column that such an alliance would be precarious and fragile. I continue to believe so. This might explain why markets have not collapsed. But the storm may well be imminent.

A superficial optimist might find consolation in the observation that Italy is not new to loud populistic rhetoric. Hasn’t Italy survived (if without thriving) the governments of Mr. Berlusconi in which strong proclamations were rarely followed by concrete measures? Even setting aside the fact that when Mr. Berlusconi was forced to step down in November 2011, Italy was on the verge of a financial crisis, the current situation is different and, in a sense, more serious.

Forza Italia was a light party entirely at the service of the interests of its leader. Ideology was more a marketing strategy than a DNA trait. In contrast, both the Northern League and the 5SM are political organizations rooted in society, with significant militant bases to which leaders are accountable. Mr. Salvini may well be charismatic and popular with his party’s rank-and-file but he has no blank check.

Nor has Mr. Di Maio who is accountable both to his nervous online followers and, no less, to his guardian party leaders, the comedian Beppe Grillo and the entrepreneur Davide Casaleggio. After years of incendiary campaigns, their people will want to see action.

Markets will not absorb a large increase in government debt

Both parties vow to reverse the supply-side reforms introduced by the governments of Mr. Monti and Mr. Renzi. Two key areas are labor markets and pensions. With the so-called Jobs Act, Mr. Renzi’s government tried to make labor markets more flexible and fair by replacing the pre-existing jungle of temporary contracts with a single, uniform contract that grants gradually increasing job protections over the tenure.

The reform also abolished the anachronistic legislation introduced in 1970 that granted disproportionate protection against dismissal to workers employed on permanent contracts. The Italian pension system was reformed under Mr. Monti’s short-lived cabinet with the goal of putting an end to the phenomenon of «baby pensions,» which used to allow Italians to retire and cash in public pensions while still in their early 50’s.

Both the labor market and the pension reforms were pillars of a (overly shy and largely unfinished) reform process to restore economic growth. They were as good for the economy as unpopular with some combative sectors of society. The yellow-green coalition will now tear down these pillars.

While abandoning structural reforms, the new government promises to engage in a very liberal fiscal policy to stimulate aggregate demand. Here, the two populist parties have different strategies. The Northern League proposes a drastic tax cut with the introduction of a 23% flat tax rate. This tax rate is a dream relative to the current tax code.

The policy appeals to the middle class of the North, a key constituency for the Northern League. The battle horse of the 5SM is instead a sizeable basic income offered to all citizens, including those who have never worked, whose generosity depends on the family size. This policy has its main constituency among the Southern voters of the 5SM.

In short, the Northern League pledges to reduce the tax revenue while the 5SM pledges to increase expenditure. The two policies together will lead to the explosion of public debt, which already accounts today for 130% of the GDP. Markets will not absorb the large increase in the government debt at the current interest rate, unless the European Central Bank is willing to buy a large share of it.

It is hard to believe that this will become part of Draghi’s «whatever it takes» approach (if it did, it would cause the rebellion of the rest of the EU). The ensuing clash will foster further anti-European sovereignist rhetoric.

A double (negative) dividend of populism

Politicians often renege on electoral promises. However, it is not realistic that Mr. Di Maio and Mr. Salvini will let their voters down and renounce to act on their program. There have been many discussions about the identity of the new ministers.

This comprises many hawks, and some more reassuring names. I doubt that this will matter. Whether the finance minister is Mr. Savona or Mr. Tria (who is marginally more moderate) will in the end make no difference. Even the new prime minister Mr. Conte will play second fiddle. Mr. Salvini and Mr. Di Maio, in their formal roles of vice presidents of governments, will cut the deals and take all important decisions.

The bargaining game between the two parties promises a double (negative) dividend of populism: satisfying one party’s request will not be possible without satisfying an equally important request from the other party. The two parties will compete in populism, accusing each other (as they already did over the past few days) of being insufficiently tough in striking a decisive blow against the establishment.

In short, as Mario Calabresi wrote in Repubblica, it is time for Italians to buckle up. The EU should buckle up, too, and get ready to handle untested scenarios. The new course of policy might soon lead Italy into the precipice of insolvency, capital controls, and even the exit of the Euro area.

The EU may well regret its uncooperative stand on immigration (on which Italy has been left alone) and on fiscal flexibility that has fed the populistic protest. It is not unreasonable to expect that the coalition will collapse even before making irreversible damage. Yet, a quick collapse of the current government would not be a solution.

It would buy some time and trigger new elections, where Italian voters are unlikely to come to their sense. Italians have chosen, through the rules of democracy, to forget reason and put themselves in the hands of healers. The time for a painless solution has irrevocably passed.