A defiant Italy puts Europe’s fiscal rules to the test

THE NEXT bout in the fight between Italy and the European Union has begun. Italy’s deadline to resubmit its budget plans to the European Commission, on November 13th, lapsed without its government flinching. To have given in, said Luigi Di Maio, the leader of the Five Star Movement (M5S), one of the two governing parties, would have been “to commit suicide”. In turn, the commission is said to be planning to launch an excessive-deficit procedure (EDP)—a disciplinary process that could lead to financial penalties—as early as next week.

The confrontation is the first test of the EU’s fiscal compact, agreed on at the height of the euro-zone debt crisis. It beefs up the commission’s oversight over countries’ budgets and its power to impose sanctions if they transgress. The commission has so far shied away from imposing sanctions on euro-zone members, but they now seem a distinct possibility.

The fiscal rules are intended to keep macroeconomic imbalances in check. But sovereign-debt crises exposed flaws in the original framework. The rules that existed before 2011—that fiscal deficits not exceed 3%, and public debt 60%, of GDP—had not taken prevailing economic conditions into account. The result was too little prudence during good times, with transgressors going unpunished. Nor was there enough stimulus during bad ones. Much-needed state spending during the crisis was frowned upon: 23 out of 27 countries were judged to have excessive deficits in 2012.

Reforms to the system in 2011-13 tried to take better account of the economic cycle, while tightening enforcement. New rules seek to calculate “structural”, ie, cyclically adjusted, deficits. Debt stocks must be brought down at a prescribed pace. The commission assesses draft budgets every year. Its decision to impose sanctions can only be overturned if a qualified majority of member states vote to do so. That is meant to make it harder for rule-breakers to sway the vote, as Germany and France did in 2003.

If an EDP is launched against Italy, it would be the first time the procedure has been used because of a breach of the debt, rather than the deficit, rule, says Gregory Claeys from Bruegel, a think-tank. Instead of declining by the required average of 3.5 percentage points a year in order to get it down to the targeted 60%, Italy’s debt ratio of 131% of GDP is forecast by the commission to be flat during 2018-2020.

Italy’s proposed fiscal deficit, though larger than the commission would like, does not breach the 3% ceiling. But the commission reckons it could come perilously close. In its forecasts published on November 8th it was more pessimistic than the government about Italy’s economic growth. It thinks the resulting lower receipts and higher spending will push the deficit to 2.9%, rather than the government’s estimate of 2.4%.

Breaking the rules is necessary for an EDP to be invoked, but is not sufficient. Starting the procedure is also a sign that Italy has exhausted the commission’s flexibility. As the rules have proliferated, so have exceptions to them, says Philippe Martin, from France’s Council of Economic Analysis. Allowances are granted to countries struck by unforeseen events, such as an economic downturn, earthquake or influx of refugees, all of which can push up government spending. Those implementing costly structural reforms, or expecting a temporary deviation from the rules, might also be let off the hook.

Critics say that such exemptions have contributed to the opacity and unpopularity of the rule book. But Italy has tended to benefit from the flexibility. It has been let off despite breaking the debt rule before. The commission estimates that Italy was granted €30bn ($34bn, or 1.8% of GDP) worth of exceptions to its deficit commitments as previous governments undertook reforms. The current one, which has undone structural reforms, eg, to pensions, can make less of an argument for special treatment. Nor has it tried to plead its case. Indeed, its rulers see confrontation with Brussels as a vote-winner.

Once an EDP has been approved by the European Council of heads of state, which could happen at their summit in December, a programme of recommendations and deadlines will follow. Italy’s progress will be monitored every three or six months. If the commission thinks Italy has not done its homework, it can impose a fine of 0.2% of GDP, and suspend payments from EU funds. Further cycles of homework and fines may follow until Italy is deemed compliant.

So far, though, the commission has been reluctant to whack countries with penalties. The nearest it came was in 2016, when Portugal and Spain were “fined” the sum of €0.The commission backed down for fear of worsening their fiscal problems and, perhaps, of stoking Euroscepticism.

Some northern states are also uncomfortable with the EU’s intrusion into national fiscal affairs, preferring that financial markets do the dirty work of disciplining profligacy instead. In October Giovanni Tria, the Italian finance minister, said that the government would reconsider its plans if the spread (ie, the difference) between Italian and German government borrowing costs were to rise to 400 basis points. (On November 13th it stood at just over 300.) The danger, though, is that investors could overreact. Market reactions can be both untimely and disorderly.

The political and economic costs of imposing fines could yet stay the commission’s hand. But the latest violation of the rules is particularly brazen, says Mr Claeys. Ignoring it risks undermining the commission’s credibility. That could well compel it to hurl its hefty rule book at Italy.