Rome tests the limits

Since Rome submitted a “revised draft budget“ to Brussels on Tuesday, the ball is now back in the European Commission’s court. The commission will not be able to accept the merely cosmetic changes to Italy’s budget proposals since Rome’s projection for the deficit and growth forecasts remain too optimistic. But the persuasive power of the instruments Brussels could use to put pressure on the pan-populist executive in the boot-shaped peninsular is decidedly limited. Initially, the European Commission could make a proposal for an excessive-deficit procedure against Italy, for example at the start of next year, on which the European Council would decide by means of a qualified majority. That would be the first act in an EU escalation drama which has already been acted out in a good number of eurozone countries. As a result, economic-policy measures or reforms would be enjoined on Italy, which would have to follow through within three to six months. In the event of non-compliance with such requirements, sanctions could ultimately ensue in the form of a fine (0.2% of GDP, or around EUR 4 billion). However, the 2019 European Elections due at the end of next May would probably impede the European Commission’s capacity to act, and thus play into the hands of the administration in Rome.

A deficit procedure would probably not have the hoped-for intimidatory effect. On the contrary, the Italian government could remain on its collision course with Brussels, for example boycotting migration agreements or refusing to make contributions to the EU budget. At the end of the day, though, an escalation in the budget spat would not serve the interests of any of the parties involved – such an escalation could put both Italy and the European Monetary Union as a whole in an unpleasant predicament both politically and economically. A necessary compromise in the budget dispute might therefore look roughly as follows: automatic brakes on spending or additional taxes would be activated in 2019 if Italy failed to reach its optimistic growth targets. For instance, the hike in the value-added tax suspended in the existing draft budget would have seen some EUR 12 billion pouring into the government’s coffers.

Otherwise, Brussels can put its hopes in the disciplinary effect of the capital market. Since the beginning of October, the Italian risk premiums have been pretty high. The political risks emanating from Italy are well-known and have therefore already been considered by investors. Given that persistently elevated risk premiums could get not only public finances but also individual troubled banks into dire straits, the Italian government would be likely to continue making verbal concessions if the market were to turn seriously choppy.

 

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