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Even though observers expected the European Commission to reject Italy’s budget, having the standoff move one step further has, at least for now, has both sides digging in.
A #Strasburgo, HO CALPESTATO (con una suola Made in Italy!!!) la montagna di BUGIE che #Moscovici ha scritto CONTRO il #NostroPaese !!! L’Italia merita RISPETTO e questi #EuroImbecilli lo devono capire, non ABBASSIAMO PIÙ LA TESTA !!! Ho fatto bene ??? pic.twitter.com/Dx5OeM0RMs
— Angelo Ciocca (@AngeloCiocca) October 23, 2018
Recall that the proposed Italian budget deficit of 2.4% of GDP for next year is within the normal deficit limits of up to 3% of GDP. And in a point not lost on Italian politicians and voters, France and Germany have broken that limit without having the sanctions gods called down on them. However, the budget rules also call for states with high debt to GDP ratios to reduce their debt loads. The budget forecasts prepared by the Italian government show that happening, but Brussels deemed the forecast growth rates to be too high. The ones they used would at best have the debt to GDP ratio stay more or less the same, an outcome the European Commission deems to be unacceptable.
The formal turndown by the European Commission gives Italy three weeks to submit a new, compliant budget. The Italian governments’ defiant posture suggests that either it won’t do anything or will submit a new document that makes only cosmetic changes. From the Financial Times:
The move is the first time Brussels has refused to endorse an EU member state’s draft budget…[Valdis] Dombrovskis [EC vice chairman responsible for the euro] and Pierre Moscovici, economics commissioner, urged Italy to immediately enter intensive negotiations…
But Italian leaders said the government would “not give up” on its plans. “We know that, if we were to surrender, we would quickly return to the pro-bank and pro-austerity ‘experts’,” Luigi Di Maio, deputy prime minister and leader of the Five Star Movement, said on Facebook. “And so we will not give up. We know that we are on the right track. And so we will not stop.”
Matteo Salvini, the other deputy prime minister who leads the far-right League, said Brussels was not “attacking a government, but a people”.
Rome had said on Monday it would ignore commission demands for a rethink, triggering Tuesday’s formal rejection by Brussels. If Italy still fails to comply it could ultimately face fines under the EU’s excessive deficit rules….
Giovanni Tria, Rome’s technocratic finance minister, has defended the measures as ways to revive a dormant economy, alleviate poverty and eventually start bringing down Italy’s debt levels from 2020.
A post earlier this month from Bruegel described in some detail how the sanctions would work. The EU has two options. One would be for failing to have a budget that converges to Italy’s medium-term objective of 0% deficit This is called “the preventive arm of the Stability and Growth Pact”. Talk about doublespeak. This sanction route would require Italy to pay a deposit:
The European Commission could thus send a warning to Italy. If the Italian government does not react within one month of the date of the adoption of the warning, the Council should, at that point, issue a recommendation urging the country to take the necessary policy measures to fulfil its European commitments. At its limit, in the preventive arm, a Council recommendation which is not respected can lead to an interest-bearing deposit of 0.2% of GDP, unless the Council decides otherwise by a qualified majority (Article 4 of regulation 1173/2011).
However, one element could delay the procedure: the SGP code of conduct stipulates that “the identification of a significant deviation […] should be based on outcomes as opposed to plans”. As a result, the intervention of the European Commission (at least as far as the preventive arm is concerned) could be deferred until the deviations are actually observed next year when the budget is executed.
The other provision the European Commission could invoke is the “corrective arm” of the Stability and Growth Pact. As you might guess, this approach is more punitive. Again from the Bruegel post:
EU countries are required to keep their budget deficit below 3% and their public-debt-to-GDP ratio lower than 60% – or if the debt ratio is above 60%, it should diminish at a sufficient pace. The Six-Pack legislation of 2011 quantified what “sufficient pace” means: the debt ratio should decline by 1/20th of the gap between the actual debt-to-GDP ratio and the 60% threshold, on average over three years. Given that Italy’s debt ratio stands at 131% of GDP, the gap to the 60% threshold is 71 percentage points, so the average annual decline should in theory be 71% divided by 20 – i.e. 3.55% of GDP per year. Therefore, the debt ratio should fall below 120% in the next three years, a criterion that the new projection of the Italian government does not meet.
So, it is not the 2.4% deficit figure that would be put forward as an argument by the European Commission, but an insufficient decline of Italy’s 131% debt-to-GDP ratio.
Let us stop and point out that the idea that Italy could reduce its debt to GDP ratio by 3.55% a year by any other route than successful stimulus of its economy is ludicrous. But the Eurozone believes in austerity. Heres what the Commission could do:
In terms of procedure, the first step would be a report by the Commission on whether to open an EDP against Italy. Three months after the submission of the budget, on the basis of this recommendation, the Council would decide whether an excessive deficit exists and, if so, to open an EDP with recommendations, deadlines and targets. At this stage, Italy would have three to six months to comply with the given recommendations – i.e. to amend its budget – before the Commission assesses if Italy has taken ‘effective action’. At that point, if Italy does not meet the given targets, the Council could decide on the type (and size) of sanctions it wants to impose on the country and assign new targets. If the non-compliance persists, the process would repeat itself.
In terms of possible sanctions, once it would enter the corrective arm of the SGP, Italy could be required (in case of serious non-compliance or if it has already been required to post an interest-bearing deposit under the preventive arm) to make a non-interest-bearing deposit until the deficit has been corrected. The country could also be sanctioned with a fine worth up to 0.5% of GDP (with a fixed component of 0.2% of GDP and a variable component). The Council could also decide to suspend part or all of the commitments or payments linked to European Structural and Investment Funds in Italy (recital 24 of regulation 1303/2013).
You might say, “Well, can’t Italy just refuse to pay?” The answer is no. The Bank of Italy is part of the Eurosystem and is thus not autonomous. Moreover, its senior employees are likely to see their career advancement opportunities as being at the ECB or elsewhere in Brussels. The Bank of Italy performs treasury functions for the Italian government. So the Commission would have the Italian government’s account at the Bank of Italy debited for any stipulated fines and charges.
Having said all of this, the Commission has launched a completely bone-headed course of action (and that’s before the fact that it is also economically backwards). Confronting Italy now has two bad effects. Rising interest rates don’t just increase the borrowing costs of the government. They also increase the funding costs of Italian banks. They’ve been wobbling on the verge of a crisis for over a year. The EU does not have a workable bank resolution regime right now. Banking experts regard the so-called Bank Recovery and Resolution Directive, made effective in early 2016, as a train wreck that will make bank runs more likely. So pushing the Italian banks into more distress when global growth is starting to look like it might falter is not a smart move.
On top of that, roughing up Italy now plays right into the hands of the Brexiteers in the UK. There is a very small, but not impossible chance that the UK will have a second referendum. If that happens, the Leave camp would be sure to wave the Commission pushing around a populist government as a bloody flag during the campaign. Why jeopardize the possibility that the UK will back out of Brexit?
The Commission could still play tough and tell Italy that if it didn’t meet its targets (as in its projected growth was not materializing) it would insist that Italy revise its budget. The government has already offered to do that, but it’s idea of when it would have to change course would probably be later than the Commission would find acceptable. Holding Italy accountable for its deemed-to-be optimistic budget would allow both sides to save face and avoid a standoff now.
The Trokia had a reason it never fessed up to during the 2015 Greece negotiations that the press never seemed to catch onto which made its brutal and economically illiterate behavior make sense in a twisted way. The biggest lender to Greece was the various Eurozone nations. Even if they had gotten over their misguided faith in austerity, they were trapped by bad accounting and budget rules. For them to recognize the losses on Greek debt (which already existed in economic terms) by reducing the principal amount would have required them to recognize the losses in their budgets on a current basis. Not only would that have been a political death sentence, but also would have required them to raise taxes and/or cut spending. By contrast, the fudges they have made provided only for modest debt relief to Greece and has the effect of spreading out the losses over decades. [Update: a commentor said that the losses wouldn’t be counted for EU budgeting purposes, so apologies for that. However, at least some politicians were very leery of taking writedowns on a current basis, since they would have to be reflected in the governments’ accounts.]
With Italy, by contrast, this looks to be a pure power struggle. The EU is already afflicted with too many upstart populist governments (see, for instance, the row with Poland over its attempt to purge judges in violation of EU rules on judicial independence). Italy appears to be getting the better of EU in a range war over migrants arriving by ship. Immigration is a very divisive issue in Europe, and Italy’s confrontational stance looks to have fed a bad impulse in Brussels to show Italy who is boss.
With Germany refusing to abandon its catbird seat of having disproportionate influence over the Eurozone by going to a more federalized spending system so as to reduce economics disparities between members and make national budgets less important, the Eurozone is destined to keep crippling its members economically. And the needed reforms are even less likely to happen with the EU contending with immigration, Trump, and Brexit. It would be better if I were proven wrong, but the Italian standoff is likely to get worse before it gets better.