For the first time in the European Union’s history, the European Commission completely rejected a member country’s budget proposal. The plan rejected was that of Italy’s, its 4th largest economy, and now being governed by a coalition of two populist parties – the Northern League and the Five-Star Movement (FS5). The EC rejected the Italian proposal as it planned to increase the deficit to 2.4% of GDP (even up to 2.9% according to some estimates), triple than that of the last government’s estimate. This might lead to Italy violating the Eurozone’s Stability and Growth pact, which stipulates that member countries limit their deficit levels to 3% of GDP and counteract Italy’s recent attempts to bring decrease its Debt-GDP ratio from a dangerously high 130% (as opposed to 60% stipulated in the Stability and Growth pact) (572, Wyplosz). The budget proposal plans to expand welfare benefits while simultaneously cutting taxes and lowering retirement ages.
This could have positive effects in the medium-term but carries long-term risks of lower incomes, higher unemployment as well as possibly inability meet debt obligations. The gridlock in negotiations between the EC and the Italian government looks to only intensify the concerns and uncertainty in the international financial market and could have ramifications across Italy’s banking sector as well as a possible domino effect across the eurozone’s banks. The steadfastness of the EC is understandable as it seeks to avoid a repeat of the sovereign debt crisis of 2008. In comparison to 2008, Italy is still plagued by many of the problems it faced in 2008 such as high levels of nation debt, unhealthy banking institutions, tax evasion and endemic corruption. The primary risk of expanding the budget drastically is the “relationship between financial vulnerability and sovereign spreads” and that “negative shocks to financial sector should translate into a much larger increase in sovereign spreads for countries with high levels of public debt.”
Thus, it could be interpreted that as an economy expands its budget (without corresponding tax increases), it commits to an increase in its deficit and debt, which leads to a “doom loop” wherein investors look for higher yields and bond prices drop. This increase in yield (vis-à-vis a German benchmark) increases the “sovereign spread” and if the spread increases too much, it could lead to rating agencies terming the country’s bonds as “junk”. Since Italian and (to a more limited extent) eurozone banks own these bonds, it increases the chances of bank failure and sometimes even a government default. Thus, it can be said that sovereign and banking sectors are caught in “mutual destabilization”
In Italy’s case, international agencies such as Moody’s have downgraded its bonds to just one level above junk status. As the spread fluctuates around 300 basis points (bp), its government has “identified 400bp as a point where it will take action to ease financial conditions”. Such degree of brazenness and risk afforded by politicians is a result of EU’s response to the debt crisis a decade ago. By granting billions of euros in bailouts to Portugal, Ireland and Greece, the EU did not respect the “No Bailout” clause in the European Treaty. Furthermore, the establishment of the European Stability Mechanism (to lend to fiscally distressed EU members) is a direct violation of the rule. The moral hazard created by the above measures has given incentives to the European political leaders to make populist promises at the elections to gain votes at the expense of fiscal health, as they know the EU will come to their government’s aid even if they spend extremely irresponsibly.
Additionally, the economic turmoil caused by the sovereign debt crisis in combination with accompanying painful austerity measures, have dramatically increased the sentiment of “Euroskepticism” across the EU. This has led to numerous questions over the “democratic legitimacy of the European project” and the rise of Euro-skeptic parties, of which the FS5 and the League are one of the most successful examples, successfully taking over power in a major EU country. This is causing the EC a massive dilemma as it doesn’t want to further intensify the euroskeptic sentiment across the continent by appearing to dictate terms to a popularly-elected national government, but at the same time, does not wish to sanction such largesse by populist leaders, which could cause widespread economic devastation. Also, since parties such as FS5 and the League expand their following and influence by going against the EUs it is in their best interest to stick to their demands and pander to their base. Thus, this makes the gridlock more favorable to their political fortunes while simultaneously damaging the public perception of the EC the longer it goes on.
However, the Italian government is exaggerating large multiplier effects of spending and the reduction of the retirement age would not lead to the youth taking over older citizens’ jobs (due to skill differentials), and this means its economic outlook remains sluggish and highly uncertain. Too much posturing against the EC is not beneficial for both the EU and Italy. If the Italian electorate turns away too much from the EU and successfully votes to withdraw from the Union or even the eurozone, the reinvented value of the Lira would be severely diminished vs the Euro and this would make it impossible for government to meet its obligations (which are euro-denominated) and this would spiral into a banking collapse in the country, leading to imposition of capital controls and closing the borders to avoid capital flight. This would lead to a domino effect across the EU as several banks holding Italian debt would be affected and would need to be recapitalized by the ECB, thus severely affecting its reserves.
The negotiations are also being drawn out by the FS5 and the Northern League, as important structural reforms are needed to galvanize the Italian economy. However, these are unlikely to be introduced due to the prominence of special interest groups in Italy. Even if these reforms are pareto-improving, they require income transfers and offer delayed political payoffs while simultaneously eroding political capital from important societal lobbies to these fledgling pollical parties. Furthermore, since the penalties and fines imposed by the EC for breaking fiscal rules take at least 6 months to come into effect, the Italian government has no incentive to resolve its negotiations at all and can continue to milk this situation for political gain.
While the EU was able to navigate the sovereign debt crisis involving Portugal, Ireland, Spain and Portugal; tackling the proposition of an Italian default and a subsequent choice whether to offer a bailout will be its biggest challenge yet due to the sheer size of Italy’s economy and financial sector. An Italian default would not only have a deep impact on the country but also on the entire EU as it is very likely that European banks hold significant interests in Italian state bonds as well as corporate debt and equity. It is certainly a doomsday scenario that could plunge the European economy back into years of crisis and recession. Thus, despite all the differences the two negotiating sides have with each other, it is in both of the EC’s and Italian government’s best interest to come to a mutual understanding – one that is best for Italians and Europeans alike.