Perhaps predictably, the new anti-establishment Italian coalition government, which took office in May, is engaged in a confrontation with the European Commission over its expansionary budget. With a significantly larger deficit planned for the coming fiscal year, the budget conflicts with the EU’s fiscal rules and reneges on commitments made by the previous government, a development that has already unsettled financial markets.
By inviting this confrontation, the government of Prime Minister Giuseppe Conte has boosted its popularity domestically. But the European Commission has significant leverage in the form of laws and macroeconomic and political circumstances to prevail in this fight. It has, for example, a crucial ally in the European Central Bank (ECB), which can inflict pain on core political constituents of Conte’s coalition. As pointed out by my colleagues Alvaro Leandro and Jérémie Cohen-Setton, a fiscal showdown with Italy involving sanctions worth billions of euros could come as early as March 2019.
Despite upcoming European elections and a potential acrimonious Brexit in early 2019, the Commission has little choice in this matter. Its credibility over enforcing the fiscal rules of the Stability and Growth Pact, revised after the euro crisis in 2010–12, is on the line, given the brazenness of the intended Italian breaches. The Commission cannot afford a repeat of the undermining of the original SGP by Germany and France back in 2003–05. Several factors are likely to reinforce the Commission’s hard line approach, not least the fact that current Commission members leave office next summer, so will not be around to conclude this process and will have no incentive to cave in to Italy before then. In addition, the Rome government has been inept in seeking political allies among other euro area members, ensuring that the European Council, which comprises the leaders of EU member states but on which only the 18 other euro area members vote, will endorse the Commission’s stance, giving it a clear political path to enforce its new fiscal rules on a large member state.
One might have expected the Commission to worry that confronting Italy would only strengthen the prospects of Rome’s governing coalition—led by Matteo Salvini’s right-wing League Party and Luigi Di Maio’s left-wing Five Star Movement (MS5)—winning in the upcoming European Parliament elections in May 2019. But from Brussels’s perspective, there is no downside to inviting such a conflict now, since Italian leaders are so popular they have nowhere to go but down.
The Commission’s tough approach no doubt also rests on the expectation that it makes sense to stoke further financial market fires under Italy sooner rather than later, as it is preferable to make the Italian government face the economic consequences of its intended actions before the upcoming European elections. Italian 10-year spreads to Germany have already risen above 300 basis points, and the Italian economy stagnated in the third quarter of 2018. The Italian finance minister, Giovanni Tria, has publicly identified a spread of 400 basis points as an “inflection point at which the Italian government would take action.” The Commission may not have to cause that much more trouble to build more short-term and perhaps politically decisive market pressure on Italy.
As for the ECB, it seems certain to end government bond purchases in December 2018, already putting additional upward pressure on Italian bond yields. In addition, the looming expiration of the central bank’s targeted longer-term refinancing operations (T-LTROs), inaugurated in 2014 and 2016, will likely squeeze Italian banks, especially smaller, regional institutions, which are large subscribers of the T-LTROs and vital to Italian small businesses, a key constituency of the League Party. Despite ongoing efforts to improve the capitalization of many of these banks since then, it seems probable that the recent rising tension in the Italian sovereign bond market and the stagnating domestic economy will again cause troubles for many of these banks beginning as early as 2019. As discussed by Holboell and Pill (2018), this is because the new Basel liquidity rules’ net stable funding ratio (NSFR) requires that a sizable share of bank funding have a remaining maturity of at least one year. In other words, Italian banks subscribing to the 2016 4-year T-LTRO will start to feel a funding squeeze as early as the first half of 2019, or precisely when the Commission’s recent actions may cause a showdown with the Italian government.
The ECB has wide discretion over how to phase out its T-LTROs at a time when rising interest rates and improving general financial conditions in the European banking system provide motivation to scale down its general provision of cheap long-term central liquidity to euro area banks. And the degree to which any redesigned “T-LTRO rollover options” will be beneficial to Italian banks in early 2019—or if Frankfurt really wants to squeeze them only announced later—seems likely to be directly related to the fiscal choices the Italian government makes in the coming months.
Finally, the Commission is well aware that if it imposes a sanction regime on Rome in early 2019, in the form of requiring it to deposit funds with the Commission of up to 0.2 percent of GDP, or about €3.5 billion, the Italian government has room to retreat at the last minute and issue a so-called reasoned request to cancel or reduce that deposit if at the last minute it complies with Brussels’s terms.
The Commission and Spain took this approach in 2016 to avoid Madrid having to pay a fine for failing to take effective action on its excessive budget deficit at the time. In their request, Spain recalled its far-reaching reform agenda, the adverse economic context, and promised to correct its excessive deficit in future years. Recalling the impressive economic performance of Spain since 2016, it is clear that the Commission made the right choice in cancelling what would otherwise have been a more than €2 billion fiscally contractionary fine.
The Commission’s confrontational approach may already be bearing fruit.
As part of the complex budget approval process in Rome, the Italian government moved recently to suggest that its spending proposals on universal basic income and a lowering of the retirement age could be cancelled if budget restraints persist. If this is the case, these new proposals would potentially eliminate what would probably be the budget’s worst long-term antigrowth element. Deputy Prime Minister Matteo Salvini of the League Party thus may have already begun to accept the political consequences of rising economic pressure. And the MS5 party leadership, for whom the universal basic income has been a key political demand, may also have blinked in the face of rising economic costs of their proposal and a possible backlash if there is an early election.
Such an outcome would be good news for Italy, as it could get a better, more growth-friendly, and sustainable composition of its fiscal policy in 2018–19. It would certainly be a great political victory for the Commission, as it would show renewed political teeth of its fiscal rules, while (again) avoiding the imposition of economically counterproductive financial sanctions.
Ultimately, an early retreat by the Italian government in this fiscal confrontation would herald “small member state status” for Italy, or (unlike France and Germany in 2003–05) a situation where the rest of the euro area (together with financial markets) can impose its political and fiscal will on a newly elected government in Rome. This development may have unpredictable future political implications in Italy but is undeniably good news for euro area policymaking and cohesion.
In the end, Italy may prove to be much closer to Portugal than to Greece: In Portugal, the leftist government of Prime Minister António Costa quietly changed fiscal and other economic policies in an orthodox direction in 2015–16 in the face of bond market spreads rising to close to 400 basis points. In Athens a highly damaging financial shutdown of the economy in the summer of 2015 was required to get Prime Minister Alexis Tsipras to change his political course and begin to adhere to the rules of the euro area and the bailout conditions.
The rest of Europe may well be able to soon breathe easier over the situation in Italy.
1. Brussels could launch a new procedure already in the coming weeks, which could culminate in as early as March 2019.
2. The potential importance of this issue was emphasized to me by my colleague Jeromin Zettelmeyer.
4. I am indebted to Angel Ubide to alerting me to these new proposals described in the Italian press.