Is Italy about to re-open the eurozone crisis with its new budget?

What is the government in Rome actually proposing? How will the EU likely respond? And could this signal the return of the eurozone crisis?

The anti-immigrant League is led by Matteo Salvini (AP)

Italian bond yields have been spiking over the past week, hitting the highest levels in four years, as the populist government in Rome has threatened to bust European Union borrowing rules.

The president of the European Commission, Jean-Claude Juncker, has pointedly compared the Italian government’s budget plans to those of Greece.

But what is the government in Rome actually proposing? How will the EU likely respond? And could this signal the return of the eurozone crisis?

Who is governing Italy?

A coalition between two populist forces. The first is the Five Star Movement, an eclectic collection of anti-politicians, with odd views such as the idea that vaccines are dangerous.

The second is the anti-immigrant League, led by Matteo Salvini.

Both groups, in the past, expressed hostility to Italy’s membership of the euro. They were the two largest parties to emerge out of March’s elections.

And, against expectations, they managed to form a coalition in May.

What is in this new budget that is so contentious?

Italy’s budget deficit this year is set to be a relatively modest 1.5 per cent of GDP. The International Monetary Fund had projected it to fall to 0.9 per cent in 2019 and to just about disappear in 2020.

But the populist government in Rome last Thursday tore up this script. It announced it would increase borrowing to 2.4 per cent in 2019 and keep it there for the following two years.

What are the European borrowing rules?

The European Union Stability and Growth Pact rules stipulate that budget deficits must be below 3 per cent. So Italy’s plans would not violate that.

But the rules also state that there must be no increase in the structural deficit – the element that does not vary with the economic cycle. The likelihood is that this aspect would be broken.

Another problem as far as Brussels is concerned is Italy’s sovereign debt pile, which is equal to 130 per cent of its GDP. That’s the highest ratio of any European country apart from Greece.

The borrowing rules say that government’s with debt of more than 60 per cent of GDP should have a “faster adjustment path”.

What have markets done in response?

Italian 10-year bond yields, or interest rates, jumped as high as 3.46 per cent this week after last week’s budget announcement, the highest since 2014.

Those sovereign interest rates are important because they affect borrowing costs throughout the economy. Higher rates make it harder for companies to service debt.

Interest rates are still way short of the 7.5 per cent levels hit in 2011 as it looked like Italy might be forced out of the single currency. But the movement has been dramatic.

And the fear is that a budget stand-off between belligerent populists in Rome and stubborn policymakers and politicians in the EU could, effectively, plunge the situation back into that emergency.

So is the eurozone crisis coming back?

The situation is volatile. Markets were particularly spooked by comments by a lawmaker from the League, Claudio Borghi, on Tuesday. He said that Italy would be better off outside the euro. That seemed to suggest that the government in Rome was actively seeking a confrontation.

But Borghi clarified those remarks shortly after, saying that leaving the single currency was “not in the government’s programme”.

Moreover, on Wednesday, the economy minister, Giovanni Tria, softened the budget plan, announcing that the deficit would not remain at 2.4 per cent for three years, but would, in fact, decline to 2.2 per cent 2020 and 2 per cent in 2021.

Is loosening the budget really a bad idea?

Many economists think fiscal policy has been excessively tight in Italy for many years and that the Italian government is actually justified in seeking to give the domestic economy a fiscal boost now. It has been through two deep recessions in the past decade and GDP remains well below its level in 2008.

Yet the composition of the boost matters. More infrastructure investment in Italy is merited and should help lift the country’s abysmal productivity growth.

Yet Five Star wants spending on a form of “citizens’ income” for the poor and a lowering of the retirement age. And the League wants tax cuts. These are measures that seem unlikely to benefit Italy's long-term public finances, even if they deliver a short-term boost to growth.