In First for Europe, Brussels Rejects Italy’s Budget
The populist Italian government has vowed to press ahead with plans to cut taxes and expand welfare and pension benefits
The European Union took the unprecedented step Tuesday of rejecting Italy’s draft budget as incompatible with the bloc’s rules on fiscal discipline, escalating a battle between Europe’s establishment and populists in Rome.
Following a meeting of the European Commission—the EU’s executive arm—Commission Vice President Valdis Dombrovskis said the Italian government was “openly and consciously going against commitments made” to drive down the country’s debt and deficit levels.
The Italian government’s effort on Monday to explain why it had planned its budget in breach of rules was unconvincing, Mr. Dombrovskis added.
The government—a coalition of the antiestablishment 5 Star Movement and the nationalist League—vowed after Mr. Dombrovskis’ rejection to press ahead with its plans to cut taxes and expand welfare and pension entitlements, insisting that Italy’s economy needs a fiscal boost.
The battle is the new front line in disputes pitting the EU’s political mainstream against rebels across Europe that have gained voter support following the region’s economic and migration crises.
Insurgent movements in Italy and elsewhere want to loosen EU constraints on member countries. Victory in the budget battle would bolster the League and 5 Star ahead of elections to the European Parliament in May, a contest in which populist movements around Europe hope to make gains.
Italy, a founding member of the EU and Europe’s fourth-biggest economy, is testing whether a rebel government can defy the bloc’s rules and skirt pressure from financial markets to back down.
Investors have dumped Italy’s government bonds and bank stocks repeatedly since the League and 5 Star agreed to govern together in May. Italy’s combination of high government debt and chronically weak economic growth make it vulnerable to capital flight.
The extra yield that investors demand to hold 10-year Italian bonds over safe German bonds hit 3.3 percentage points last week, the widest gap in more than five years. That has battered shares in Italy’s banking sector, which is heavily exposed to its national debt.
However, markets remain far more stable than during the eurozone debt crisis of 2010-2012. Back then, the spread between Italy and Germany peaked at 5.6 percentage points.
Most investors expect Rome and Brussels ultimately to reach a compromise over the budget. Plus, today’s economic backdrop is better than before. Italy’s economy is expected to grow by around 1% in 2018, in contrast to its sharp contraction during the debt crisis.
League and 5 Star leaders have brushed aside investor pressure to compromise over the budget. The Commission had hoped that this pressure, coupled with its courting of Italy’s pragmatic finance minister, Giovanni Tria, would nudge Rome into compliance.
“Markets love Italy more than some European institutions do,” 5 Star leader Luigi Di Maio said.
He predicted “weeks of strong exchange with the European Commission, but both the Commission and the markets will come to understand that this is a government that believes in what it is doing.”
The Commission has much to lose. Failure to stop a flagrant breach of agreements on fiscal discipline would weaken economic-governance rules created after Europe’s debt crisis that are already tarnished by the waiving of regulations for France. Some member countries have indicated they believe the Commission has already been too lenient with Italy.
Officials also know that disciplinary proceedings against Italy will play into the hands of 5 Star and League politicians, who routinely paint Brussels as a remote bureaucracy hostile to the needs of ordinary Italians.
Under the EU’s protracted procedures, Italy has three weeks to submit a revised budget and the Commission then has three weeks to respond. The budget fight could thus come to a head in early December. That will likely be a sensitive time for Italy, since the European Central Bank has said it plans by the end of 2018 to cease its bond purchases, which have been vital in moderating Italy’s borrowing costs.
If Italy refuses to adopt a compliant budget, the resulting EU disciplinary proceedings could lead to fines equal to 0.2% of Italy’s gross domestic product and the freezing of some funding. Those fines can grow over time if Italy continues to defy Brussels.
Defiance toward Brussels has lifted the Rome government’s popularity. Over 60% of Italy’s electorate support the League or 5 Star, according to recent polls. A similar share of voters say they support the draft budget.
To go into effect, the budget must be approved by the Italian parliament before the end of the year.
The government’s weakest spot is the vulnerability of Italy’s banks, and thereby its economy, to investor flight. Further pressure on Italian bonds could erode the capital of Italian banks and force them to restrict their lending to the country’s businesses and households.