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Five-Star Movement leader Luigi Di Maio, centre, arrives for a meeting with the leader of the League party, Matteo Salvini, in Milan on May 13, 2018.

Flavio Lo Scalzo/The Canadian Press

Italy’s two biggest anti-establishment parties moved close to forming a government that would put the euro area’s third largest economy in the hands of an untested populist movement that threatens to scare off investors and rattle the European project.

Over the weekend and into Monday, the Five Star Movement (M5S) and the League drafted a broad governing plan designed to end more than two months of political limbo since the inconclusive March 4 election. But late on Monday, the two parties asked Italian President Sergio Mattarella for a few more days to come to agreement on certain key issues, including the name of the potential prime minister

The Italian election marked the first populist victory in a big European country.

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It showed that the European populist movement did not necessarily peak last year, when Marine Le Pen, leader of the Euroskeptic, anti-immigrant National Front, went down to defeat in the 2017 French election. The National Front’s German equivalent, Alternative for Germany, fared better in the September election but ultimately did not prevent Chancellor Angela Merkel’s centrist, pro-EU forces from forming a new coalition government.

M5S and the League were the two main winners in the March election, which saw the centrist parties of two former prime ministers, Silvio Berlusconi and Matteo Renzi, lose millions of voters to the populist parties.

M5S’s leader, Luigi Di Maio, 31, and his League counterpart, Matteo Salvini, 45, would not publicly reveal their short list of candidates for prime minister. As head of state, Mr. Mattarella can accept or reject their choice.

While M5S and the League were not natural governing partners, they managed to bang out a governing platform that included a guaranteed income for the poor, a rollback of pension reform that will drop the retirement age, a flat tax, the expulsion of illegal immigrants and a closer relationship with Russia.

The League, which has said the euro is killing Italy’s ability to compete, wants a feasibility study on a debt instrument that would, in effect, act as a parallel, internal currency that could be used to pay taxes, social-security contributions and government suppliers. While any European country can legally introduce a parallel currency, the European Central Bank would probably consider it an attack on its currency monopoly and the integrity of the euro zone.

Some economists have already pronounced the fiscal package unveiled by the two parties as overly costly in a country with one of the world’s highest levels of debt relative to the size of its economy, barely perceptible growth, rising poverty rates and a crushing youth-unemployment rate of 32 per cent.

In a Monday note, economists at the French bank Société Générale said “this government is unlikely to have enough political and fiscal room to maneuver to deliver [such a] large fiscal slippage.”

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M5S and the League claimed 55 per cent of the Italian vote in March after appealing to voters who were weary of years of economic stagnation and austerity demanded by Brussels, a stubbornly high unemployment rate and EU-mandated fiscal rules that the parties argued did not give Italy the spending latitude to promote growth and job creation.

While both parties could be labelled Euroskeptic – the League far more so than M5S – they have dropped their pre-election pledges to hold a referendum on the euro. But their expensive economic platforms would likely break the EU’s rules of budget deficits. Those rules insist that deficits be no more than 3 per cent of gross domestic product.

According to Italy’s Corriere della Sera newspaper, the flat tax would emerge as the most costly item on the two parties’ agenda. Their draft agreement says the flat tax would be set at 15 per cent, rising to 20 per cent for families earning more than €80,000 (about $120,000) a year. Italy’s pension agency has said the flat tax could cost as much as €30-billion a year, almost double the figure set out by M5S.

So far, investors have not expressed much fear that the new government will drive up budget deficits. The yield on benchmark Italian government bonds barely rose in recent weeks as the prospect of a high-spending government took shape. Investors, apparently, are taking comfort in the ECB’s massive bond-buying program, which has pushed down bond yields across the euro zone.

But some analysts think investors might be in for a shock if the new government makes good on even some of its economic promises. They note that the ECB’s bond-buying program is winding down, leaving the Italian debt markets with ever less protection, and that Italy has almost no fiscal wiggle room. “I believe that Italian risk is being dramatically underpriced,” said Nicholas Spiro of London’s Lauressa Advisory. “The markets assume that the ECB will come to the rescue again [in Italy] but how can it? There could be another financial crisis in Italy.”

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