After Italy: Dealing with the Populist Menace in Europe

After the election, no government can be formed in Italy unless at least one of the two big radical parties support it. In the Chamber of Deputies, the 5Stars have 229 and the Lega 124 out of 630 seats.

In the 315-seat Senate, the combined tally of the 5Stars (114 seats) and the Lega (57) would also add up to a majority for a hypothetical alliance of the two major protest parties. The scary scenario of 5Stars and Lega teaming up and pursuing a radical agenda is numerically possible.

The leaders of both parties, Luigi di Maio for the 5Stars and Matteo Salvini for the smaller Lega, have already staked their claim to become prime minister. Salvini presenting himself as the candidate for the centre-right alliance that includes Silvio Berlusconi’s Forza Italia and two smaller groups with a combined result of 267 seats in the Chamber and 135 seats in the Senate.

Big risks

Both Di Maio and Salvini give the impression that they would like to govern. To advance their prospects of finding partners, both seem to have ditched the most dangerous part of their erstwhile agenda, a euro exit, with even Salvini explaining yesterday that “holding a referendum on the euro is unthinkable.” That still leaves three other significant risks:

1. The period of serious reforms in Italy — ranging from Mario Monti’s pension reform to Matteo Renzi’s labour market reforms to some modest progress on banking issues under Paolo Gentiloni — seems to be over.

Instead, a government in which one of the two radical parties plays a leading role is more likely to reverse some of these reforms. One example is to scrap parts of the Monti pension reform as both radical parties have promised in their election campaigns.

During a cyclical economic recovery, partial reform reversals may not matter much. But every step that makes Italy’s fiscal position less sustainable in the long run could come to haunt the country during and after the next cyclical downturn.

2. Both radical parties have made unfinanceable tax cut and spending pledges. The 5Stars have proposed a guaranteed monthly minimum income of 780 Euros and the Lega wants a 15% flat personal income tax.

Even if they put only a fraction of their wilder promises into practice, they would likely get in trouble with the fiscal watchdogs in Brussels. That conflict could escalate over time.

The French government may be somewhat helpful in that it may adopt a more lenient approach than in the past. However, even its “patience” is bound to have strict limits, especially when it comes to fiscal costs in partner countries that stem from reversing sensible reforms.

One can also expect the bond markets forcing an Italian government that tries to implement some of the radical ideas back into line, just as they did in similar “rose-tinted” times in the early days of the Mitterrand presidency in France.

Over the course of such a conflict, the issue of a hypothetical Italian euro exit may come up again.

3. A much bigger political concern is that, as a matter of principle or as a bargaining chip, an Italian government under the sway of one of the big radical parties may try to obstruct whatever reforms France, Germany and other countries may be planning for the EU and the Eurozone.

While it is marginally possible that France and Germany may decide to accept this, it is much likelier that they would still go ahead with their own plans and exclude an obstructionist Italy from such deeper co-operation.

However, it is important to note that Italy could be a prime beneficiary of some of the planned reform steps, such as turning the ESM into the ultimate backstop if a big bank needs to be wound down or a gradual build-up of a Eurozone deposit insurance. For that reason alone, even a government in which Italian radicals play a key role may think twice about blocking progress in Europe.