The European Union has taken the unprecedented step of rejecting the Italian budgetby Luigi Scazzieri / October 24, 2018 / Leave a comment
The European Commission request that Italy revise its budget for 2019 marks an unprecedented step. Italy now has three weeks to comply, but the two sides appear to be on a collision course. The Commission will find itself in an increasingly awkward position: it could double down on demands that Italy rewrite its budget and move towards a hefty fine if they refuse, or it could cut Italy’s coalition government some slack—but both choices would have negative consequences.
Italy’s coalition government of the nationalist League and populist Five Star presented a draft budget that increases the budget deficit of the eurozone’s third largest economy to 2.4 per cent of economic output in 2019, from a projected 1.6 per cent this year. This is likely to increase Italy’s public debt, and is a clear breach of EU fiscal rules that mandate how quickly governments reduce their debt.
Italy’s prime minister Giuseppe Conte has described the budget—which includes tax cuts, increased welfare spending and a partial repeal of a pension reform—as “beautiful.” The government insists the increased spending is necessary to boost growth and strengthen the economy. Very few believe this: the risk premium on Italy’s debt has been rising.
It will be difficult for Italy to back down and meet the Commission’s demands. The coalition government has already scaled back its original manifesto promises, which would have inflated the deficit to around 7 per cent of gross domestic product. There may be some scope for small spending cuts or tax rises, but it is very difficult to imagine the government agreeing to a deficit below 2 per cent—which would still represent a breach of the bloc’s fiscal rules.
That leaves the EU with a tricky choice: follow its rules to the letter and punish Italy, or grant Rome latitude in the hope the rising cost of financing its debt forces it to revise its plans.
If the European Commission decides to escalate the confrontation, opening an excessive deficit procedure and threatening to fine Italy, it risks spooking the financial markets further. So far the rise in yields on Italian government bonds has been contained. But an increase in confrontation could spark a selloff. While many hope this could force Italy to back down, it may also prove difficult to contain…