Italy’s expansion budget plans are increasingly drawing the ire of the European Union. A confrontation could destabilise the Italian economy, one of the EU’s largest, and potentially plunge Europe back into crisis. What’s going on between Rome and Brussels?
EU members are supposed to follow the bloc’s budget rules limiting government debt and deficits. But Italy’s new proposals for 2019 ignore previous commitments to reduce both of these, in favour of expanding welfare and cutting taxes.
Italy’s leaders have been on a collision course with the EU since taking power earlier in 2018. They say the bloc’s technocratic rules have caused economic discomfort and blame EU-imposed austerity for the country’s double-dip recession after the 2008 financial crisis. Since then, Italy’s growth has remained at under 1 percent, behind most other European economies, and its youth unemployment still tops 30 percent, exceeded only by Greece and Spain. Rome wants more spending, which it says will boost growth, productivity, and employment and, in turn, make servicing the debt easier in the years ahead.
Meanwhile, the government’s borrowing costs are rising. Government bond yields – a measure of how much the government pays to issue debt – have nearly doubled since May to their highest level in four years. This means investors see Italy as an increasingly risky bet.
Why does this matter outside Italy?
There are several big reasons. First, systemic financial risk in the EU. At more than $ 2.6 trillion, Italy has the world’s fourth-largest foreign debt. At roughly 131 percent of gross domestic product (GDP), it is more than twice that EU rules allow. If investors get spooked and bond yields spike, as happened to crisis-ridden European economies in 2010-2012, Italy’s debt payments could spiral out of control. That could mean an Italian default, which would hit banks across Europe that hold Italian sovereign bonds. Italian banks, which are still weak from the euro crisis, hold a lot of these bonds. If they continue to lose value, banks could fail, lending could dry up, and economic growth could plummet again – the so-called banking doom loop. And if Italy takes the unprecedented step of leaving the euro currency and returning to the lira, it would cause massive losses to investors across the continent, potentially triggering another financial crisis.
If the eurozone is threatened, Italy would be too big to rescue. In 2012, the European Central Bank (ECB) stepped in with a dramatic promise to do “whatever it takes” to prevent contagion. The EU and the International Monetary Fund bailed out Greece, Ireland, Portugal and Cyprus. The largest bailout package, to Greece, topped $300 billion. But with a GDP of nearly $2 trillion, Italy is the bloc’s third-largest economy – there simply aren’t enough funds to bail it out. There are also concerns that the ECB used up all its firepower fighting the last crisis and has few tools left to make cheap credit available or buy up troubled bonds.
What happens next?
On Tuesday (23 October) an unprecedented move by the European Commission led Brussel to reject Italy’s 2019 budget.[i] Now Rome has three weeks to rewrite it. Then EC could approve or reject the new draft budget – the latter is a step it has never taken. Brussels could eventually impose fines and other sanctions if Rome refuses to change course. However, the substantive budget dialogue is expected to start in early December. This coincides with the period when the European Central Bank is likely to start shrinking its asset purchase program – a program that Rome has greatly benefited from. If bond yields rise, Italy will be ready to change the budget. The options are adjustments to pension plans and basic income. The government may react if yield on Italian bonds spikes against yield on German securities. At the moment, yields on Italian bonds are 3.5%, while on German bonds – only 0.4%.
Eyes are now on how markets will react. Bond yields have not yet approached the levels they did in 2012, when ECB hit the panic button. But Italy’s growing fiscal imbalances may soon lead ratings agencies to downgrade its creditworthiness, which could pave the way for further problems and make debt payments still more expensive.
The Italian government insists that these concerns are overblown and defends its right to make its own decisions. But with Eurosceptics across Europe ramping up efforts for next year’s European Parliament elections, Rome may be itching for a fight with Brussels – a showdown with unpredictable economic consequences.
European Affairs Commissioner Pierre Moscovici has called the budget plans “an unprecedented deviation” from European Union rules. However, the EU needs to be “sensible” and give in to Italian demands – or the entire European project could come crashing down, according to a leading financial strategist.
Bryn Jones from Rathbones admits Italy were in a “strong position” amid huge concern in Brussels over stoking anti-EU anger in the third largest eurozone country.
“I think it is important that the European Union give them some leeway and allow them to have some kind of deficit. Italians are actually in a very strong negotiation position. If the EU don’t want to jettison Italy from Europe, the whole project dies. They have to be quite sensible”.[ii]
He added that the latest EU tactic – to let the financial markets pressure the politicians in Rome – was a “very risky move” that could backfire across European economies. The financial analyst said he was not confident that the solution would be reached in the short-term.
Jones is not the only one seeing a potentially aggravating problem. Barclay’s Senior European Economist Fabio Fois said that the “risk of escalating is rising” and the likelihood increasing of an EDP against Italy.[iii]
Top figures in Brussels are concerned that higher Italian spending could increase the country’s debt pile, which is already the second largest in the eurozone. The Commission sent a letter to the Italian Finance Minister Giovanni Tria, warning him that Italy’s 2019 draft budget seems to point to a “particularly serious non-compliance with the budgetary policy obligations laid down” in European rules.
Mr Moscovici said: “With our letter we ask the government to move closer to European rules, because it cannot remain at 2.4 percent deficit and with a structural deficit of one and a half point”.[iv]
There is no evidence that undermining the European Union’s budget limits on borrowing leads to prosperity for a country, but it is clear that such actions are costly for all in the single currency area – warned the head of the European Central Bank. Speaking to European Union leaders at a summit devoted to the eurozone integration, Mario Draghi said EU budget rules (the Stability and Growth Pact) had to be respected in the interest of all.[v] While not naming Italy directly, it was clear that Draghi was referring to Rome’s plans to raise borrowing in order to finance election promises of higher spending and tax cuts.
Backed by the Eurosceptic Five Star Movement, Matteo Salvini pledged to do the “exact opposite” of what EU demanded to cut Italy’s debt. Italy’s government had to reply to Commission’s latest letter, following which EC could request submission of a new draft budget within three weeks. Although it has the power to sanction governments whose budgets don’t comply with the EU’s fiscal rules (and has threatened to do so in the past), Brussels has stopped short of issuing fines to other member states before. The rules state that deficits should not exceed 3% of GDP and public debt must not exceed 60% of GDP – a far cry for many European countries.
Although Italy’s draft budget envisages a deficit within the 3 percent limit, increasing the deficit from a previous lower target has angered the Commission because the European member states are meant to work toward adhering to the rules, not deviating from them.
Now the European Commission could recommend to the European Council (EU heads of state) that an “Excess Deficit Procedure” is launched against Italy. Basically, “the EDP requires the country in question to provide a plan of the corrective action and policies it will follow, as well as deadlines for their achievement”. According to the rules, Euro area countries that do not follow up on the recommendations may be fined by the European Commission.
Everything new is actually well-forgotten old
What’s happening today is largely rooted in the so-called “euro crisis” or “debt crisis” – a continuing crisis affecting the euro area countries since the end of 2009. It is a combination of a public debt crisis, a banking crisis and a crisis of growth and competitiveness. It consists in the following: some countries have difficulties in financing debt, yields on their government bonds are rising, banks are decapitalized and face liquidity problems, and economic growth in the euro area is weak and unevenly distributed across countries. The crisis has made several eurozone members unable to repay or refinance their government debt without the assistance of third parties.
In 1992, members of the European Union signed the Maastricht Treaty, under which they pledged to limit their deficit spending and debt levels. However, in the early 2000s, some EU member states were failing to stay within the confines of the Maastricht criteria and turned to securitising future government revenues to reduce their debts and/or deficits. Countries are selling rights to receive future cash flows, which allows governments to raise money without violating the debt and deficit targets, sidestepping best practices and ignoring international standards. This allowed the sovereigns to mask their deficit and debt levels through a combination of techniques, including inconsistent accounting, off-balance-sheet transactions, and the use of the complex currency and credit derivatives structures.
From late 2009 on, fears of sovereign defaults in certain European states developed in investors as a result of rising levels of private and public debt worldwide, along with a wave of several European countries’ debt downgrading. The causes of the crisis varied across countries. In several countries private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. In Greece, the increase in debt is associated with high public sector wages and pension commitments. The structure of the eurozone as a currency union (i.e., one currency) without fiscal union (e.g. different tax and public pension rules) contributed to the crisis and limited the ability of European leaders to respond to challenges. European banks own a significant amount of sovereign debt, such that concerns regarding the solvency of banking systems or sovereigns are negatively reinforcing.
In addition to the series of political measures and rescue programmes undertaken to address the crisis in the eurozone, the European Central Bank (ECB) also played its role by lowering interest rates and providing cheap loans of more than one trillion in order to maintain money flows between European banks. On 6 September 2012, the ECB calmed financial markets by announcing free unlimited support for all eurozone countries involved in a sovereign state bailout/precautionary programme from the European Financial Stability Facility (EFSF) and the European Stabilisation Mechanism (ESM). An instrument of this support is the buying-in of already issued government securities (on the secondary market) from those countries, whereby the ECB helped lowering the cost of their financing through new issues.
The crisis has not only led to adverse economic repercussions for the worst-hit countries, but has also had a significant political impact on the ruling governments in 8 of the 17 eurozone countries, resulting in a shift of power in Greece, Ireland, Italy, Portugal, Spain, Slovenia, Slovakia and the Netherlands. Such a domino effect by the economy in politics cannot be ruled out today if the shocks continue.
The eurozone crisis is becoming a social crisis for the most affected countries, with Greece and Spain having the highest rate of unemployment in the currency union – 27% in the middle of 2013. Today, these parameters are relatively more stable, at 21% 15%, but are still very high for developed countries.[vi]
Is the future of the eurozone at stake?
There have been speculations about the break-up of the eurozone almost from its onset. Many economists, mostly from outside Europe, condemned the design of the euro currency system from the beginning because it ceded national monetary and economic sovereignty but lacked a central fiscal authority to regulate the fiscal policy. When faced with such problems, the Economic and Monetary Union would prevent effective action by individual countries and put nothing in its place. Some analysts contend that the eurozone does not fulfil the necessary criteria for an optimum currency area, though it is moving in that direction.
As the debt crisis expanded beyond Greece, threatening other countries like Italy, such economists continued to advocate, albeit more forcefully, the disbandment of the eurozone.[vii] If this was not immediately feasible, they recommended that Greece and the other debtor nations unilaterally leave the eurozone, default on their debts, regain their fiscal sovereignty, and re-adopt national currencies. Projections in 2011 suggested that if the Greek and Irish bailouts should fail, an alternative would be for Germany to leave the eurozone to save the currency through depreciation instead of austerity. The likely substantial fall in the euro against a newly reconstituted Deutsche Mark would give a huge boost to its member competitiveness. So far, this option seems unlikely.
Iceland, which is not part of the EU, is regarded as one of Europe’s recovery success stories. It defaulted on its debt and devalued its currency, which has effectively reduced wages by 50% making exports more competitive. Floating exchange rates allow wage reductions by currency devaluations, a politically easier option than the economically equivalent but politically impossible method of lowering wages by political enactment. Sweden’s floating rate currency gives it a short-term advantage, while structural reforms and constraints account for longer-term prosperity.
For years, Italy has benefited from favourable tax treatment by the Commission, using different options to achieve higher spending. The country is too big to save through the standard European Stability Mechanism (ESM). And it is not just technical issues about the ESM capacity, but first and foremost political, most of Italy’s population do not want to even try using the ESM for Italy. So, a big, huge, debt restructuring would be the only way. Most of Italy’s national debt (around 66 percent) is owned by Italian institutions and individuals, meaning they could be the hardest hit in a debt crisis.
But Italy insisted it will not reach the point where it is unable to pay its debts.
Minister of European Affairs Paolo Savona told Italian MEPs in Strasbourg that he had no intention of threatening the stability of the single currency.
“I do not intend to take any action against the euro. In fact, I want to strengthen it,” he said.[viii]
So, the coming weeks will really be fateful for his country, the European Union and its common currency.
[i] Italy budget: European Commission demands changes, ВВС, October 23, 2018, available at https://www.bbc.co.uk/news/world-europe-45954022
[ii] McBride, James, Does Italy Threaten a New European Debt Crisis? Council on Foreign Relations, October 18, 2018, available at https://www.cfr.org/article/does-italy-threaten-new-european-debt-crisis
[iii] Ellyatt, Holly, If Brussels rejects Italy’s spending plans, here’s what could happen next, CNBC, October 22, 2018, available at https://www.cnbc.com/2018/10/22/european-commission-on-italys-2019-budget—what-could-happen-next.html
[iv] Smith, Oli, ‘Give in to Italy or EU dies’ Financial warning ROCKS Brussels as European CRISIS looms, Express, October 20, 2018, available at https://www.express.co.uk/news/world/1034152/Italy-EU-warning-Salvini-Brussels-European-crisis-budget-plans
[v] ECB’s Draghi: undermining EU budget rules carries high price for all, Reuters, October 18, 2018, available at https://finance.yahoo.com/news/ecbs-draghi-undermining-eu-budget-155855077.html?guccounter=1
[vi] Kokkinidisq Tasos, Greece’s Unemployment Highest in Developed World, Greek Reporter, August 4, 2018, available at https://greece.greekreporter.com/2018/08/04/greeces-unemployment-highest-in-developed-world-chart/
[vii] Chu, Ben, Is Italy about to re-open the eurozone crisis with its new budget?, Independent, October 3, 2018, available at https://www.independent.co.uk/news/business/analysis-and-features/italy-eurozone-debt-new-budget-matteo-salvini-five-star-a8566671.html
[viii] Gavin, Harvey, EURO ON BRINK: Italy budget plans could SINK single currency – ‘sleepwalking into CRISIS’, Express, October 4, 2018, available at https://www.express.co.uk/news/world/1026926/eurozone-news-single-currency-warning-italy-debt-crisis-budget
Related news
