Italy’s horror show has just started -- and it’s bound to get worse.

The country’s economy stagnated in the third quarter, according to figures released on Tuesday. The slowdown may be part of a wider trend: The eurozone economy expanded by a meager 0.2 percent in same three months. But it’s clear that the uncertainty which has accompanied the rise to power of Italy’s populist government has started to take its toll.

The deceleration will throw a spanner in the plans of Finance Minister Giovanni Tria, who is betting big that the economy will expand by 1.5 percent next year so he can fund a raft of giveaways while keeping Italy’s enormous public debt on a slight downward path. This growth forecast had already been judged too optimistic by Italy’s own fiscal council. It now looks like an impossible mission. The government would be wise to reverse course on its most damaging measures before borrowing and indebtedness spiral out of control.

Italy’s slowdown has its roots in the weakening of the eurozone economy. Protectionism is hurting exports, which had helped to drive growth for both Italy and the rest of Europe in 2017. German car production has also stalled as automakers struggle to adapt to new emissions tests. Since Italy provides so many components for this industry, this may have played a role. The hope is that as vehicle production rebounds and if the protectionist winds abate, the economic deceleration will prove temporary.

However, Italian industry faces some additional and unnecessary headwinds of its own. Since the creation of the new government in the spring, Rome’s borrowing costs have shot up. This is making it costlier for banks to fund themselves on the financial markets. For customers, lending rates have only begun to creep up -- but the threat of further rises will have weighed on the minds of executives. It’s hard to invest big when policy uncertainty is so great.

The government has also passed laws which will make life for companies harder. In July, a labor market reform spearheaded by Five Star Leader Luigi Di Maio made it more expensive to hire workers on a temporary basis, while increasing redundancy pay for workers hired on permanent contracts. We still don’t know exactly how much damage these changes have caused, but they are likely only to reduce hiring.

Giuseppe Conte, Italy’s premier, said the slowdown was expected, which is why the government has chosen to pass an expansionary budget. Rome is targeting a budget deficit equal to 2.4 percent of gross domestic product, far more than what had been agreed with Brussels. Many observers fear the end result could be a lot worse, given it is based on growth forecasts that aren’t plausible.

The government’s explanation is self-serving and wrong-headed. Italy’s economy risks entering a recession precisely because investors fear the coalition has no clue about how to spur growth. The budget only pays lip service to the need to boost investment and includes a range of measures -- such as the lowering the retirement age -- which only will damage debt sustainability without doing much to lift growth. Higher borrowing costs will weigh on consumers and companies, canceling out any expansionary effects of the budget. This will inexorably cause some fiscal slippage, raising the concerns of investors and worsening this vicious circle.

The government would be wise to return to the drawing board before it is too late. It needs to abandon some of its most damaging proposals, including its pension overhaul, and concentrate the little money it has on public investment. This change must be communicated openly, and not by some poorly understood subterfuges -- like delaying measures so as not to spend the money allocated to them. A clear policy shift would help to reduce borrowing costs, and potentially create some room for a little more public spending.

The League and Five Star may think their economic recipe will ultimately prove right. But this looks like the most dangerous of gambles. The risk to Italy is big and will not go away. Better to stop now than regret it later.


Ferdinando Giugliano
Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. -- Ed.

(Bloomberg)