Economists see potential nightmare in new Italian government

MILAN (AP) — The prospect of a populist government in Italy, the eurozone's third-largest economy, has spooked European partners and investors who fear its euroskeptic, budget-busting program could shake the region's cohesion and undermine its growth.

Rival populist forces — the anti-establishment 5-Star Movement and right-wing League — squeezed their often competing agendas into a government program that suggests a spending spree that would add to Italy's debt load, already Europe's heaviest after Greece, with little detail on financing.

But what is most concerning to economists, other eurozone nations and financial markets is a euroskeptic attitude that both political parties share, even if they omitted language from an early draft that called for ways to allow countries to exit the common euro currency.

Lorenzo Codogno, a former Italian Treasury official, says he was "speechless" at proposals in the program, saying it reflected the parties' "complicated relationship with Europe."

"Although they toned down the anti-euro rhetoric ... the mentioned plans put Italy clearly on a collision course with Brussels," said Codogno, who runs a consultancy, LC Macro Advisers.

The program was first outlined last week and would be the blueprint for a government if it is approved by the president in the coming hours or days. It includes pet projects to establish a basic income for needy Italians and a two-tier flat tax. The parties also want to cancel scheduled increases to sales tax, and eliminate some taxes at the gas pump. But the most worrying to many are plans to roll back hard-won pension reforms passed by the last parliament.

Analysts say all of this could cost 170 billion euros ($200 billion), or 10 percent of GDP. That would add to a perilously big debt pile of 2.1 trillion euros, or 132 percent of GDP. By comparison, U.S. debt is about 105 percent of GDP and Germany's 68 percent.

Economist Raj Badiani of IHS Markit says that when coupled with plans to repatriate hundreds of thousands of migrants — a potential labor pool in aging Italy — the rollbacks could erode Italy's ability to pay for its massive pensions system, which currently costs 15 percent of GDP each year.

"If they are going to send these people home, and push back the retirement age again, it makes the pension system into something not sustainable in the medium to long term," Badiani said.

An early draft of the parties' program had included a call to cancel 250 billion euros in Italian public debt, a move that would go against EU treaties and would be practically unfeasible, analysts say. That call was removed from the final program, but alerted investors to the extent to which the two parties are willing to contemplate unorthodox economic policies.

So far, the jitters in financial markets — which are largely measured in the bond market — have been relatively contained. But that is largely thanks to the European Central Bank's massive stimulus program in which it is buying bonds, including Italian ones.

The 10-year bond yield, a measure of investor concern over a country's likelihood of default, has risen from around 1.74 percent last month to 2.29 percent. While that's a sharp rise, the rate is still low, thanks to the ECB bond-buying program, analysts say. When financial markets really worried that Italy might fall out of the euro in 2011, the rate hit 7 percent.

Badiani says the recent bond yield increases are mere warning shots and the new government needs "to be very careful."

"It is one thing to say we want greater control over fiscal policy, over our banking sector. It is another to talk about debt relief. That makes people nervous and the markets will respond aggressively, as they have in the past."

Italy has in recent years reduced government spending aggressively, but it still pays massive amounts — 60 billion euros a year — to service its existing debt. That leaves it vulnerable to shifts in the bond markets.

In a worst case scenario, a spike in bond yields could render Italy unable to finance itself over the long term. Italy's debt pile is almost seven times bigger than Greece's and could prove too much to be bailed out by its European partners.

Short of such a nightmare scenario, the parties' program sets Italy up to clash with the EU's executive and fellow member states by breaking public spending rules.

The Italian business daily Il Sole 24 Ore estimates the plan's cost would push the budget deficit to 5.8 percent, well above the EU's agreed ceiling of 3 percent.

Manfred Weber, the German who heads the center-right parties' group in the European Parliament, called on the prospective Italian coalition partners to end the discussion about the euro and its rules.

"This is playing with fire, because Italy is highly indebted," Weber told German news agency dpa Monday. "Irrational or populist acts could cause a new euro crisis."

The League's leader Matteo Salvini dismissed such concerns.

"They have nothing to worry about. The government we want to form wants to make Italy grow and create jobs, to bring companies to Italy that invest, to make work more stable," he said.

The government program estimates that extra money that businesses and consumers would keep thanks to a flat tax and minimum salary for poorer households would provide economic stimulus by boosting spending and investment. In turn, that could offset the rise in the deficit and debt. But economists warn that some of that money will go into savings, and the program does not include long-term structural changes needed to ensure sustainable growth.

In his bottom line, Codogno says the government program contains "unrealistic objectives, spending plans that go well beyond what is feasible, i.e. a dream book. But I have to say, it looks to me more a nightmare than a dream book."