Italy's populists take power, but can they control the country's purse?

Antonio Masiello | Getty Images News | Getty Images

Matteo Salvini (L), Deputy Prime Minister and Italian Interior minister, Italian Prime Minister Giuseppe Conte (2L), Luigi Di Maio (2R), Deputy Prime Minister and Labor Minister, and Giancarlo Giorgetti (R) Undersecretary pose for a picture during the first cabinet meeting of the new government at the Palazzo Chigi on June 1, 2018 in Rome.

The creation of a new Italian government proved to be a long, uncertain and publicly painful process for all involved.

But after almost three months, Lega and Five-Star Movement (M5S) formally joined forces last week, with a hybrid cabinet consisting of some rather odd political bedfellows, drawn from across the ideological and professional spectrum.

These individuals must now embrace an equally disparate set of challenges that may require rather contradictory, or at least competing, solutions.

The two parties share a well-publicized distrust of Brussels, but their separate agendas highlighted in their governing contract show that both are willing to push policies that will place greater strain on Italian state finances. This could have serious implications not only for ties with Europe, but also for the long-term stability of the partnership.

Lega leader Matteo Salvini recently quipped to reporters that he expected the new government to last for a decade. But as the latest popular polls showed his party closing in on M5S, investors may well ask if the coalition can possibly last if Salvini does not swiftly fulfil his major campaign promises.

Those include the introduction of a flat tax — originally planned at 15 percent, but now likely to be a two-tier system that ranges from 15 and 20 percent — as well as a wide-scale deportation of more than half a million undocumented migrants.

Economists including the former IMF director Carlo Cottarelli, who just last week was briefly tapped as a possible stop-gap prime minister, have questioned the underlying arithmetical logic.

Cottarelli predicted the tax cuts will cost around 50 billion euros, and while proposed changes to the treatment of migrants in Italy might have a less significant impact on government spending, they may prove very unpalatable to Italy's European partners.

If Lega delivers on another M5S-backed plan to roll back earlier reforms to the pension system, Cottarelli suggested a loss of another 8 billion euros each year. And his predictions are far from anomalous among mainstream economists.

M5S' electoral promises are no less expensive, especially the introduction of a universal basic income that became a keystone policy for this upstart political party after Italy's financial crisis. With national unemployment still close to 11 percent, it would add a further 17 billion euros to a yawning fiscal chasm, according to Cottarelli.

All these measures would necessitate greater borrowing, and given that both these populist parties have provided little details on the financing plans for these new programs, their introduction will very likely place the government in contravention of both domestic and European fiscal rules.

Add in higher bond yields each time the market gets jittery; the fact most of Italy's sovereign debt is held by Italians; the ongoing reality that many local banks remain very exposed to government bonds; and a fresh assurance from German Chancellor Angela Merkel that Berlin will not countenance any write-down in Italy's debts, and there are few options left to the new coalition government that would not hurt its own population.

But any public reneging on the most high-profile promises will prove extremely damaging for the parties' leaders and their levels of popular support.

Under sufficient pressure, the electoral rivalry between M5S leader Luigi Di Maio and Salvini could re-emerge, manifesting itself in parliamentary disputes over spending priorities and rendering the coalition — and its current uneasy cooperation — entirely untenable.

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