Recent developments in Italy, including unsustainable debt levels and an unstable coalition government, underline how fragile the eurozone remains.

We can’t stop worrying about Italy’s government bonds, or Buono del Tesoro Poliennale (BTP). Italy’s debt levels are unsustainable, and the new government was elected on the back of expansive, and expensive, pledges to lower taxes and increase spending. These pledges are not consistent with the eurozone’s fiscal rules. Italy’s economic turmoil matters more to the rest of the world than the protracted Greece debt crisis; Italy has the third-largest sovereign debt market — after the United States and Japan — and its credit rating makes it only just eligible for inclusion in the Bloomberg Barclays Global Aggregate Bond Index. Given how much passive money is invested there, things could get ugly very fast if the ratings agencies take a dim view of Italy’s fiscal future.

There are many actors on the stage right now. The EU has its rules, which can be interpreted with a certain flexibility, but the direction of policy is clear. Germany and its northern neighbors believe strongly in their approach, while President Emmanuel Macron’s administration in France cannot afford to lose an argument with populists about spending. So, the EU will cut Italy some slack, but only a little.

Populism and the budget

The Italian government is an unstable coalition. The Five Star Movement (M5S) wants more spending but is pro-EU. La Liga wants lower taxes and a lower pension age, and it has some strongly eurosceptic elements. The balance of power between the two parties is changing. They ceded some authority to Prime Minister Giuseppe Conte and economy minister Giovanni Tria, who both agreed on a budget to stay on the right side of the EU. The markets and the ratings agencies are also key players. The ratings agencies matter because Italy’s rating is close to the level at which we’d have to worry about index eligibility. Italy is rated BBB by Fitch and S&P, and Baa2 by Moody’s. Since Moody’s rating is on negative watch, two notch downgrades would mean exclusion from the Barclays Global Aggregate Bond Index. A large amount of capital would get reallocated away from BTPs if Italy lost its investment-grade rating.

The Italian government is an unstable coalition.

The 2019 budget negotiations have reignited turmoil among Italy’s political factions and the EU. There are differences in how to meet both a conservative fiscal target and EU rules. Tria had threatened to resign over a bigger fiscal deficit, the technocratic center has lost influence, and the eurosceptic wing of La Liga has gained power.

Trial balloons

Markets have been volatile as headlines have appeared about various deficit targets. The headlines are, in part, trial balloons designed to test the reaction of the markets and the EU. The politicians reacted pretty quickly when they saw Italian yields rise when some lax budget targets were published. The ratings agencies have maintained a calm distance, waiting for a reaction from the European Union. S&P is scheduled to update Italy’s rating on October 26, and Moody’s has indicated it will review the ratings around the end of October.

The headlines and the trial balloons have been about nominal deficits, and EU rules are also couched in these terms. These are a bit misleading since they are influenced by the cyclical position of the economy: Fiddle with the assumed growth rate, and you can do wonders with the headline deficit. It’s useful to think in terms of the cyclically adjusted primary balance. While the “cyclical adjustment” can be controversial, it is, at least in theory, a better indicator of fiscal sustainability. The latest Italian proposals suggest a cyclically adjusted primary deficit of about 1.0% of GDP, whereas the trajectory the EU had agreed with the prior government would produce a surplus of 0.6% of GDP.

There’s only so much that can be done by putting optimistic assumptions about growth and revenues into a budget. Italy will have to cave at some point or precipitate a crisis. But the eurosceptic Italians are probably playing a fairly long game and are reasonably content in this episode to be seen fighting the EU before conceding. They think this is the best way to build political strength at home. At some point, all of this could explode into a major crisis because the debt trajectory is simply unsustainable given the economic and political parameters. The endgame is not yet in view.

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