Rome’s battle with Europe will show if Italy is too big to fail, strategist says

  • The new populist cabinet in Rome is set to cut taxes and increase public spending.
  • This decision will challenge European fiscal rules and is an alarming prospect for EU officials, given that Italy has the second highest pile of government debt in the region.
Giuseppe Conte delivers a declaration after a meeting with Italian President Sergio Mattarella as part of consultations for a new government at the Quirinale Palace on May 23, 2018 in Rome, Italy.
Franco Origlia/Getty Images
Giuseppe Conte delivers a declaration after a meeting with Italian President Sergio Mattarella as part of consultations for a new government at the Quirinale Palace on May 23, 2018 in Rome, Italy.

There's a standoff emerging between the European Union and the new Italian government, one which will ultimately answer the question whether Italy is too big to fail, a strategist told CNBC Thursday.

The new populist cabinet in Rome is set to cut taxes and increase public spending. This decision will challenge European fiscal rules and is an alarming prospect for EU officials, given that Italy has the second highest pile of government debt in the region, about 132 percent of gross domestic product.

German leader Angela Merkel made it clear during an interview over the weekend that the euro zone will never be a debt-sharing union. Meanwhile, the chief of the German Bundesbank also warned this week that there are a lot of differences between the economies within the euro and that each government needs to focus on reforming their own.

Discussing the policies presented by the new Italian government, one strategist said a confrontation between Italy and the euro zone, and wider EU, looked likely.

"I think these battle lines have been drawn and everybody knows exactly what they are doing," Simon Derrick, chief currency strategist at BNY Mellon told CNBC's Street Signs Thursday.

"The key question is ultimately whether Italy is too big to fail," Derrick said. "It is too big to fail, and that's where this is really going come down to, probably at some point later this year when the discussion about the spending program will start," he suggested.

Italy is the third largest economy in the euro zone. Derrick's comments suggest that if the government in Italy moves ahead with further spending and increases the level of public debt, the euro zone might be forced to support the country given its size and importance to the stability of the entire 19-member region.

The recent political turmoil in Italy has affected other European markets. The yields on Greek, Spanish and Portuguese bonds followed the same rising trend, signaling that investors saw higher risks in getting their loans repaid by those specific governments too even if they were not the ones announcing further spending.

Billionaire George Soros warned in an opinion piece Tuesday that European leaders should stop criticizing Italy and instead offer help in order to avoid further support for populist leaders. "The EU must not punish the Italian people for the sins of its governments," Soros wrote in The Guardian newspaper.