Good old Europe is currently facing another internal crisis. This time it sees Italy and the European Commission playing chicken over Rome’s new spending plans. Italy remains defiant over its proposed budget for 2019, whilst Brussels refuses to accept the budget. Both parties are waiting for their ‘opponent’ to blink first and come to a compromise. This escalating standoff has created anxiety within the financial markets, and has caught the attention of many, spreading fears over a replay of the Greek debit crisis.
Read on for the what, why and what now of the ultimate European dilemma.
What is going on?
Italy’s budget drama began last September, when the country announced its 2019 spending plans to the European Commission.
Each year EU member states present to the European Commission and to the other member states draft budgetary plans for the following year. The Maastricht Treaty has set a limit of annual deficit GDP ratio of 3% to guarantee the stability of the Eurozone. If the presented budgets are considered unrealistic and/or to pose serious threats to the Union, the EC can ask a member state to submit a new version of the budget.
What happened is that Italy’s newly elected government agreed to a sharp increase in deficit spending. Specifically, the country aims at a deficit target of 2,4% of its GDP. The plot twist was that this target is three times bigger than what the previous government had agreed with Brussels (0.8%).
It is more common to talk about the debt-to-GDP ratio, which is sovereign debt: this measures the ratio between a country’s government debt and its GDP. For example, the United States have a debt-to-GDP ratio of 105%, United Kingdom of 85%. In this case we are referring to annual deficit target, so how much a country intends to spend more than it will earn on an annual basis. By setting a target of 2,4%, Italy is essentially aiming at spending 2,4% more than it will earn in 2019.
For the first time since the creation of the Eurozone, Brussels has rejected a member state’s budget, and has given the country three weeks to come up with a new one, setting the deadline for the 13th November 2018. Another unprecedented step was the Italian government’s refusal to do so. On this date Italy has confirmed that it will remain defiant over its budget. The strong position took by Italy is reflected in Deputy Prime Minister Matteo Salvini’s words: “We will not subtract one single euro from the budget”.
This is how the standoff has started, and, at least for now, the matter seems far from being resolved.
Why does Italy want to increase its deficit spending?
Deficit spending is generally considered good as it fosters economic growth, especially in periods of poor spending or poor demand. In fact, by using deficit spending governments are able to increase their spending without increasing the costs on the population.
The main reason for Italy lies in its new government coalition.
The country managed to renovate its government after elections last March, albeit through many difficulties. Its government is made up of a wobbly coalition between the populist ‘Movimento Cinque Stelle’ (5-Star Movement) led by Luigi di Maio, and Matteo Salvini’s far-right ‘Lega Nord’ (Northern League). You may argue that these two parties couldn’t be more different (and, truth be told, they are), but both of them made a number of appealing promises to the Italian population during their election campaigns, and they are now trying to stick to them. These include giving a minimum income to the unemployed, cutting taxes and eliminating extensions to the pension age (people will be able to retire at the age of 62, which is probably the lowest pension age in Europe). They state they are aiming at “eliminating poverty” within the Italian population. Because they want to alleviate costs on Italians, they need to increase their deficit.
With this audacious ‘manovra’ Rome is aiming at increasing demand amongst Italians (they would theoretically have more money to spend) and is forecasting an economic growth of namely of 1.6% in 2019 and of 1.7% in 2020. In an interview with the Financial Times, Deputy Prime Minister Mr. Di Maio has even argued that the Italian spending plans will become a ‘recipe’ to foster economic growth at a European level, that Europe must end its austerity plans and adopt an approach similar to the Italian one, which he was not afraid to compare to Roosevelt’s New Deal provisions that had aided the US during the Great Depression.
Rome’s reasons are very clear: this expansive budget is here to foster economic growth and reduce Italian public debt without further burdening the Italians, who are still impoverished from the financial crisis, and whose economy still hasn’t recovered. What is also clear is that the country is not willing to back down to Europe, nor to enter in any sort of compromise with the authorities in Brussels.
Fair enough. So where is the problem?
Not everyone sees it that way.
Even though Italy’s target deficit is within the 3% limit admitted by EU laws, Brussels does not believe this a smart move for the country.
The first worrying aspect is Italy’s sovereign debt, often considered the elephant in the room in the euro area. Worth more than 130% of its GDP, in Europe this is second only to bailed out Greece and is more than double EU’s limit of 60%. Unsurprisingly, then, the European Commission believes that an increase in this debt might be unsustainable for the country’s already fragile economy. This huge sovereign debt is also paired with the slowest rate of economic growth in the European Union. Italian economy showed no growth in the third quarter of 2018, following a 0.2% growth in the previous period. Unemployment is also a pressing issue in the peninsula. Whilst it was 7%, it has now reached the value of 10%.
Hence, the Italian budget relies on growth projections which, to Brussels, seem more than unrealistic. If these optimistic growth forecasts are not met, the annual deficit of 2,4% could become a lot higher and Italian public debt unsustainable.
Market reactions
Together with Brussels’ angry faces, Italy has also been hit by some negative market reactions.
After this rattle has started, Moody’s rating agency has lowered its rating of Italian debt at one notch above junk because of concerns about Italy’s fiscal strength and the stalling of reform plans. This essentially means that there is little certainty on whether Italy will be able to repay its sovereign debt, and that, at least to Moody’s, it is not safe to hold Italian bonds.
The main problem with junk bonds is that many investors are not allowed to hold securities that are considered non-investment grade (for instance, funds may have a clause in their statute obliging them to hold securities with a minimum rating). Moreover, the ECB itself would not be able to buy Italian government bonds if their rating reaches junk level, as the bank is allowed by its statute to buy bonds with a rating of at least BBB.
A ‘junk bond’ is an instrument that refers to a very high-yield or non-investment grade bond. These bonds usually have a rating of BB or under and are considered having a high default risk.
To name just one example of what this can provoke: the ECB would not be able to continue its quantitative easing program in Italy, as its bonds would be prohibited.
Quantitative Easing (QE) is an unconventional expansionary monetary policy. The central bank buys securities from member states’ banks to add liquidity (cash) in the capital markets. This makes it easier to borrow money as it lowers interest rates and is therefore aimed at inducing more spending and boosting the economy.
This downgrade had an impact on Italy’s bonds yields: they reached a five year high of 3.4 points. This impacted the gap between Italy’s 10-year government bond yields and Germany’s– lo spread, as it is called in Rome. This gap has widened to around 310 points, its highest level since 2013 (to offer a comparison, the spread was at 130 points last May).
Bond yields: The money that investors realise on a bond is called yield. But this is not limited to the interest rate they get annually. An investor may decide to sell the bond before its maturity to another investor for a higher or lower price. If the investor is able to make money selling the bond, that is also part of the yield. A higher yield means that the bond pays more. Hence, it is riskier.
What does this mean? The state will have to pay higher interest rates on its bonds (aka more spending), and every time one government bond gets to maturity Italy will have to replace it with a higher priced bond (again, more spending), as investors will expect higher revenues from a riskier investment.
Moreover, now that Rome has confirmed it will not change its budget plans, the European Commission can sanction the country financially as per EU regulation and cause further spending.
Italian economy is already pretty unstable, and if the battle between Rome and Brussels intensifies, this situation can only get worse. It is clear how the ingredients for a new crisis are all there, and many fear it too. But because Italy is the EU’s third largest economy it would be way too large to be bailed out as Europe did with Greece, and the effects that an Italian collapse can have on the Euro area can hardly be overestimated.
What now?
At the moment, the main questions are two.
Firstly, how far is Italy willing to go? The government could be forced to resign by the gravity of the economic reality and lack of international acceptance (as it has happened in 2011 with the Berlusconi government). Or, they could convince their electorate that the Italian economy is strong enough to undertake this budget, and that the European bureaucrats are just trying to kill Italian sovereignty with imposed austerity.
And secondly, how strict will the EU response be? Will they let Italy go for its own path, paving a way to more rule breaking, or will they force Italy into EU regulations?
The time horizons for this dispute are, however, quite long. After the Italian’s response last Wednesday, the EC has another two weeks to reply to the Italian reply. And the new budget, whatever its form will be, will not be implemented until next May.
Other EU capitals and distrust: does Europe need fixing?
This Italian budget crisis is only another blatant example of how distrust amongst EU member states lies at the core of the general malfunctioning of the Union, beginning from its fiscal policy.
Facing European widespread criticism on the Italian budget, deputy prime minister Mr. Di Maio has twitted that European bureaucrats don’t approve it because “this is the first budget that has been drafted by Rome and not by Brussels”. Mr. Matteo Salvini has spoken to Italian newspapers arguing how “the prescriptions imposed by Europe – and by the previous Italian Governments – have increased the public debt and made Italy poor and precarious”.
On the opposing front we have northern Europeans, with Angela Merkel and France’s prime minister Emmanuel Macron greatly criticising Italy’s new government and its economic manoeuvre. Even Sebastian Kurz, Austria’s chancellor, has claimed that “Austria is not prepared to stand behind the debts of other states while those states are actively contributing to market uncertainty”.
Since the creation of the eurozone, Germany and other northerners have never felt enough solidarity towards the southern countries to share their debts. And, on the other hand, southern European states (with Italy and Greece at the forefront) perceive Brussels as an outside imposition they are increasingly not willing to listen. This situation is today even worsened by the Eurosceptic Italian 5-Star Movement’s election to government.
In order to enable smoother conversations and an easier coordination and implementation of its policies, Europe should focus more on renewing solidarity and trust amongst its member states. In this way Italians will stop seeing Brussels as an outside imposition on its sovereignty, and Northern Europeans will not consider the south of Europe just a financial burden to the Union. This is of pivotal importance for a continent with an economy is big enough to impact the whole world.
Camilla is a member of TCLA’s writing team. She is a third year social and political studies student at UCL. She is currently on her year abroad in Germany.
You can reach out to Camilla in our forums by clicking here.
