24 October 2022

LSE: The challenge facing Italy’s new coalition

On 22 October, Giorgia Meloni was officially sworn in as Italy’s first female prime minister. However, the new Italian government might soon come under pressure to address soaring energy prices and support struggling families and businesses. Corrado Macchiarelli and Mara Monti write that Meloni’s right-wing coalition will face a delicate balancing act between maintaining the support of its electorate and upholding commitments undertaken with Brussels.

Regardless of how you view the Meloni-led coalition government politically, there are economic reasons not to panic too much (at least for now). In fact, the response from the financial markets so far has been a mere blip. Meloni’s political future undoubtedly depends on the state of the economy. But recent events have already served as a warning to the new coalition about the possible consequences of reckless tax cuts: Meloni simply needs to look at what has happened in the UK.

When Liz Truss, the (soon to be former) UK Prime Minister, unveiled a tax plan on 23 September, with costs both for short term inflation and medium term growth, the pound hit a record low versus the dollar and intra-day volatility of government borrowing costs rose dramatically. The Bank of England was forced to step in by purchasing bonds when the yield on the UK 30-year gilt surged above 5% for the first time since the early 2000s.

For Italy, the political responsibility is much larger. The country has one of the highest debt burdens in the eurozone and among advanced economies (147% debt/GDP ratio). The government also issues debt in a currency the Bank of Italy has no direct control over, and it therefore has to rely on the ECB’s new anti-fragmentation tool, which comes with heavy strings attached and cannot be used to correct for “policy errors” – using ECB President Lagarde’s latest words.

Markets remain calm – but for how long?

The first important sign of what’s to come and how much investor nervousness will be sustained will be the response to Italy’s 2023 budget proposal. This is scheduled to be sent to the European Union by the middle of next month.

Based on recent estimates produced by the National Institute of Economic and Social Research regarding Italy’s term premium (a measure of investors’ confidence), Italy – a country that has had historically elevated term premia due to structural factors and high public debt – has experienced term premia increases of over 200 basis points, decoupling in trend from the rest of Europe, and getting close to that of Greece. It is highly likely that markets are reacting more strongly to domestic political developments than other fundamentals, given the outcome of the recent election.

Investors will be watching the incoming government for any indications of budgetary divergence from the previous administration, much as happened for the UK. Yet, the new administration has enormous economic challenges ahead. Despite departing Prime Minister Mario Draghi’s best efforts, Italian growth predictions for next year have been cut to less than 0.5%, making it more difficult to sustain debt. Meloni, who is deemed far less credible than her predecessor, must handle increasing interest rates and skyrocketing inflation, which portend a cost of living crisis.

One specific suggestion Meloni made during her campaign was to lower the tax rate for self-employed individuals to 15% on revenues up to €100,000 each year. Her party wants to reduce the income tax structure from four rates to one rate by 2027. Meloni thinks she can pay for the plan by taking away about €9 billion that was allocated in 2023 for a programme to alleviate poverty known as “citizens’ wages” and money from the government’s settlement of unresolved tax evasion cases. These reductions are meant to stop the government from increasing the national debt.

But Meloni has also committed to raising the minimum pension and blocking an increase in the retirement age, as well as mitigating the effects of the energy crisis after the war in Ukraine. It is unclear where the funding for these measures would come from without adding to the debt, which is for now projected to decrease to 142.5% by 2027 after hitting a peak in 2020.

Italy needs Europe as its debt of GDP remains close to 150%

Compared to earlier this year, Meloni has now adopted a more tolerant stance toward Brussels. The incoming administration’s fiscal strategy might have significant repercussions if it deviates too far from the budgetary guidelines of the European Union.

First of all, Italy may be deprived of a portion of the EU’s NextGenerationEU economic recovery plan, totalling €800 billion. At the end of September, the European Commission authorised the next €21 billion of Italy’s €191 billion EU pandemic recovery budget, consisting of grants and loans, taking the total Italy has now received to €46 billion (or 24% of the NGEU ringfenced monies until 2026). Future tranches are conditional on the continuation of structural reforms and the achievement of investment targets, both of which were agreed upon by the departing PM Draghi....

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