The Financial Crisis of 2007–9 hit Italy hard. It was one of the countries which faced problems with its deficit. By 2018, the situation had not improved a great deal. Elections in March 2018 failed to produce any outright winners, and protracted negotiations eventually saw a coalition government consisting of the Lega Nord (Northern League)
and the populist Movimento 5 Stelle (M5S) or Five Star Movement as the main forces of government. The coalition government faced many challenges but a key one was the size of the Italian budget deficit. In the latter part of 2018, it was estimated that the size of Italy’s national debt was around 130 per cent of GDP. The new government had promised to increase pensions and introduce a basic income which would put further pressure on government spending.
This would potentially force the government’s deficit up to near levels which would incur sanctions from the EU. The new government had planned to run a deficit of around 2.4 per cent of GDP in 2019, 2020 and 2021.
In December 2018, the Italian government said it would trim the deficit to 2.04 per cent in an attempt to find a compromise with the EU. The announcement avoided the prospect of sanctions but did not please other political groups in Italy. However, bond prices rose following the announcements and the yield on 10-year bonds fell by 14 basis points or 0.14 per cent to 2.8 per cent.
The argument over the budget deficit in Italy was unlikely to be over, however. In the early part of 2019, it was reported that there was disagreement among the coalition partners. Ultimately, if a deficit is to be cut then two things must happen – either individually or in combination. Taxes must rise or spending must be cut – or a combination of the two. The European Commission was reported to have said that the Italian government had agreed to increase VAT in the event its deficit got worse in 2020 and 2021; it was also reported that around €2 billion of planned spending would be held back, and privatizations would be accelerated to increase revenues.
It will be important for the Italian government to show that it has control over the country’s finances because if it doesn’t, markets will lose confidence and there is every chance that bond prices would rise to levels which would make it hard for the government to rollover its debt.
Critical Thinking Questions
1 Why is trust such an important part of the smooth functioning of the sovereign bond market (i.e. bonds bought by national governments)?
2 The austerity measures which many governments introduced after the Financial Crisis have caused much hardship to millions of people across Europe. This has led to a wave of populist governments vowing to spend more on social welfare, improving pensions and cutting taxes, that have gained political power across Europe. To what extent do you think that the threat of sanctions by the EU is a sufficient deterrent for populist governments to be more financially responsible with regard to government debt?
3 One of the challenges facing the Italian economy is a weak banking system. Why is a weak banking system a potential threat to the health of an economy such as Italy’s?
4 What is the present value of a €500 million bond, with an interest rate of 2.4 per cent and 30 years to maturity?
What would the present value be if the interest rate was 2.04 per cent?
5 Explain the significance of the phrase: ‘bond prices would rise to levels which would make it hard for the government to rollover its debt’.