Rome's populist budget frays nerves

After weeks of tug-of-war games, Italy's coalition government — made up of the populist 5-Star Movement and the right-wing Northern League party — last week approved their first budget. Under the proposals, the country's deficit will rise to 2.4 percent of gross domestic product (GDP) in 2019.

Read more: Italy sends EU Commission disputed budget proposal

New social security benefits are also planned, on the orders of 5-Star leader Luigi Di Maio, who is also the labor and social policy minister. Cuts to the country's tax system, demanded by Northern League party leader Matteo Salvini, are also in the bag.

The introduction of two tax bands of 15 and 20 percent are meant to boost the economy but could mean considerable revenue losses. In addition, costly pension reforms — which have not yet been factored into this budget — are being readied, following a promise by Italian Prime Minister Guiseppe Conte.

A further sweetener will see the coalition drop a long-planned increase in the country's sales tax (VAT), which analysts say will only widen the hole in the country's finances.

Even so, Finance Minister Giovanni Tria, an economics professor not aligned to either party, has tried to limit public spending. He pushed for the deficit to rise to a maximum of 1.6 percent. Apparently, he initially threatened to resign after pressure to further boost the state's debt levels but is now likely to remain in office.

In Brussels, reaction to Italy's draft budget has ranged from strong rejection to moderate concern. EU Commissioner for economic and financial affairs, taxation and customs, Pierre Moscovici, has warned that the budget "lies outside our rules and regulations."

The EU's Stability and Growth Pact, first agreed in 1999, stipulates that EU member states must ensure their budget deficits don't exceed 3 percent of GDP, and while Italy's budget doesn't cross the line, it will push debt levels in the wrong direction.

Deficit limit three times higher

"At 2.4 percent, we clearly stay within the [deficit] limit," Economics Minister Luigi Di Maio argued before the draft budget was finalized last month.

However, he forgot to mention the second part of the pact. A country's total debt should not account for more than 60 percent of its economic output. Italy, however, is at a record-breaking 131 percent, more than double that figure. The previous Italian government had agreed with the European Commission to gradually reduce its debt and set a deficit goal of 0.8 percent.

The populist government now argues that 16 EU member states out of a total of 28 currently violate the EU's 60-percent rule. It also claims that the boost in public spending will lead to higher growth and subsequently more state income that could be used to pay down debt.

Read more: Italian deputy minister: 'Italy not eurozone's next Greece'

But economist Alessio Terzi, from the Brussels think tank Breugel, told DW that the 3-percent rule in Italy's case was "misleading."

"Countries with a debt level such as Italy's can no longer accrue debt, but should slowly pay it off. The deficit should be much lower, certainly under 2 percent, in order to reduce debt and achieve moderate economic growth."

Terzi calculates that the Italian populists' combined promises will cost around €100 billion ($115 billion). "It's good in principle that a government is trying to keep its election promises, but it must be balanced with the reality of Italy's economic situation." The Italian financial and banking system is fragile, according to the economist.

Plan to ignore the markets

5-Star leader, Di Maio, has promised that the proposed budget "will change Italy" for the better. He said the plans would enable the government to "repay our debts because economic growth will be higher than expected." As well as not exceeding the 2.4 percent deficit limit, Italy will invest some €15 billion in infrastructure, he added.

Di Maio has previously declared that Italy would "no longer satisfy rating agencies and financial markets while stabbing Italians in the back." He predicted the European Central Bank (ECB) would simply buy up Italian debt securities indefinitely in order to finance the country's needs. In doing so, he ignored the fact that the ECB is not legally allowed to do so unconditionally, and is also in the process of reducing its indirect purchases of debt instruments from eurozone countries.

Read more: Italy's Matteo Salvini: EU has 'ruined our country'

There's been a cool reaction to Italy's budget from the financial markets, from which Di Maio vowed to make his country "independent" during the Italian election campaign earlier this year.

The Milan stock exchange also dropped by 4 percent on the news, and Italian bank shares, in particular, felt the pressure. Italy remains more dependent than ever on private investors and saw yields on its 10-year government bonds rise suddenly after the draft budget announcement.

Read more: Italian bonds hit over possible EU revision of 2019 budget plan

On Friday, ratings agency Moody's downgraded Italian debt, citing a "material weakening in Italy's fiscal strength."

Brussels' next move

The EU is concerned that a rise in Italy's deficit could risk instability when the next recession hits. Many economists fear a financial crisis in Italy could quickly spread across the eurozone.

"In the end, the populists will also have to listen to the markets," an EU diplomat said of Italy's budget defiance. "The reaction of the markets is also much faster and more resounding than EU policy can ever be."

Last week the European Commission urged the Italian government to revise its anti-austerity budget, but after Rome vowed to proceed with its plans, Brussels will announce its next steps on Tuesday.

The Commission will most likely seek to avoid an open dispute with Di Maio and Salvini, for fear of playing into the populists' hands. The two leaders have, for months, told Italian voters that Brussels is forbidding them from helping Italy's poor.

Although most analysts think Brussels will issue a set of strict recommendations for Rome to reduce its existing debt, and keep new loans under control, a formal deficit directive, with the threat of punitive measures if ignored, is unlikely.