"There is a strong inclination in Europe to use the occasion to teach Italy a lesson. If the EU follows this line, it will dig its own grave."
-George Soros

The new Italian government

Italy is now run by a coalition consisting of the populist party Movimento 5 Stelle (M5S) and the far-right party Lega Nord – an interesting cocktail to say the least. The coalition has threatened to throw fiscal prudence to the wind and to embark on a spending spree that will drive debt-to-GDP much higher from already elevated levels.

Financial markets didn’t respond kindly to the news. Bond yields rose sharply (Exhibit 1), and equity prices dropped. Banks performed particularly poorly in the aftermath of the formation of the new government (Exhibit 2).

Exhibit 1: 1-day change in 2-year Italian sovereign bonds
Exhibit 1: 1-day change in 2-year Italian sovereign bonds
Source: Bloomberg, The Daily Shot
Exhibit 2: FTSE Italia all-share bank index
Exhibit 2: FTSE Italia all-share bank index
Source: The Daily Shot

Lega Nord is the smaller party of the two in the Italian parliament but the senior partner in the new government. It is definitely perceived to be far-right in nature but, in reality, it is more multifaceted than that.

It is indeed correct that some of the policies in its manifesto can only be characterised as far-right. Having said that, its desire to extend the social safety network of Italian society can best be compared with the social-democratic model of Scandinavia, so there is more to the story than what first meets the eye. M5S, on the other hand, is relatively straightforward. It is truly a populist party.

The coalition’s top three objectives are to:

1. extend the social safety network;

2. lower taxes; and to

3. reduce immigration.

Should the new government succeed in implementing that programme, economic growth will almost certainly accelerate, and so will the public budget deficit.

That said, most people who follow Italian politics closely seem quite certain that the new government won’t last that long, but I note that those who are of this opinion are mostly part of the establishment, so no wonder they have their doubts.

If taxes are reduced as dramatically as the new government have indicated, and if the spending power amongst ordinary Italians suddenly start to rise again, you never know what will happen next.