Italy: Should it be prevented from running up a huge fiscal deficit? - Natixis

Patrick Artus, Research Analyst at Natixis, points out that the government coalition of M5S and the League in Italy wanted to cut taxes and increase public spending, and perhaps increase the fiscal deficit from 2% of GDP to 5% or 6% of GDP.

Key Quotes

“Should Europe prevent Italy from conducting this policy? To answer this question, we must examine the externalities generated by Italy’s fiscal policy on the other euro-zone countries:

• Could a massive Italian fiscal deficit drive up the other countries’ interest rates? Recent developments show that the answer once again is yes;
• A massive Italian fiscal deficit would weaken the euro by reducing the euro zone's external surplus, but would this be a serious problem for the other countries?
• The problem could be that a financial crisis might break out in Italy that would require the support of the other euro-zone countries (for example via the ESM), as the other countries then would suffer a negative externality by being forced to lend to Italy. This would happen if Italy's fiscal deficit became so large that Italy’s external surplus disappeared, and if the country then was unable to finance an external deficit.”

“A negative externality would then appear, working through long-term interest rates, and which would justify controlling Italy’s fiscal policy. Everything also depends on the size of the increase in Italy’s fiscal deficit: if it was not too large, it would not generate any negative externality on the other countries; this would no longer be the case if it was so large that it threatened to trigger a financial crisis.”

“But even if Italy’s fiscal deficit remained quite small, there would still be a negative externality working through interest rates.”