In the midst of last October’s budget battle with the European Union, Italy’s firebrand deputy prime minister, Matteo Salvini, said the government would “not backtrack by a millimeter” on its spending plans. The next month, Salvini said the government’s target 2019 deficit of 2.4 percent of output was non-negotiable. But a week later, he acknowledged that the government might cut the deficit target by 0.2 percentage points – but no more. By mid-December, Rome and Brussels had settled on a deficit nearly 0.4 percentage points below the government’s starting point (though still above what the EU wanted). All the tough talk from both sides, it turned out, was part of a negotiation.

This is by no means unusual, in Europe or elsewhere, and yet somewhere in the ensuing seven months the lesson was forgotten. Until this week, Italy was once again vowing to ignore “old and outdated” EU spending rules and let its ballooning deficit lift it out of stagnation. The EU’s executive body, the European Commission, had resumed threats of disciplinary procedures against Rome that could lead to unprecedented fines. But on Tuesday, Italy’s prime minister sent a letter to the commission highlighting unexpectedly high revenues and minor spending cuts to bring the 2019 budget back in line with the targets agreed last December, and on Wednesday the European Commission agreed to hold off on opening a so-called excessive deficit procedure.

But don’t celebrate yet: In the coming months, Rome will begin work on its 2020 budget, which Salvini insists will include a flat tax that, by the Treasury’s own estimate, could cost as much as 60 billion euros ($68 billion). (That’s about 3.4 percent of gross domestic product; estimates from Salvini’s League party have ranged from 15 billion to 30 billion euros). The fall is sure to bring another showdown, but the next round will probably end like the last two – with a compromise – because neither side can afford the alternative, and because as long as there is an EU, Italy (and Salvini) is more influential inside than out.

An Italian Exit?

At issue is Italy’s inability to get its public debt under control. The EU’s Stability and Growth Pact requires, among other things, that member states work to bring their debt down to 60 percent of GDP. As of 2018, Italy’s debt stood at 132.2 percent of GDP and is expected to reach 135.2 percent next year. Rome argues that austerity hasn’t worked and that it needs to be permitted an expansionary fiscal policy to return to growth. Brussels argues that Italy hasn’t really tried serious reforms and that no amount of spending will help if the government doesn’t make changes to improve competitiveness.

Both arguments contain some truth. The twist, however, is that the EU has no direct power to force Italy to do anything. Its toolkit contains only barely intelligible bureaucratic processes that culminate in gradually increasing fines. These can hurt, but they can’t force compliance. Yet the EU has formidable allies in the form of investors and credit ratings agencies. Whether Italy’s government is right about taking on new debt is irrelevant if no one will lend to it, or if it can’t afford the rates that investors demand. Were Italian bonds to fall below investment grade (S&P and Fitch rate Italy two levels above junk, and Moody’s and DBRS score it only one notch over the threshold) it would be dropped from investment-grade indexes. The European Central Bank could also refuse to accept Italy’s bonds as collateral and cut its banks off from ECB credit if its rating falls to junk status, further decreasing demand for Italy’s bonds and, therefore, raising its rates.

Italy’s only real leverage, meanwhile, is to try to spook Brussels into a compromise. In the most recent iteration, Rome has flirted with introducing a “parallel currency” that critics – and many supporters – say would be the first step toward abandoning the euro. The plan calls for the printing of small-denomination, zero-coupon bonds known as mini-BOTs, short for Buoni Ordinari del Tesoro, or Ordinary Treasury Bonds. The state would use mini-BOTs to settle its public administration arrears, which according to the Bank of Italy amounted to about 53 billion euros at the end of 2018. Recipients could then use the mini-BOTs (which would exist in paper form) to pay future taxes, or to pay for public goods and services. Mini-BOTs could also be traded around the economy, though crucially the state would not require the private sector to accept them nor mandate that they maintain parity with the euro.

There are several technical problems with the idea, but it’s the political constraints that are least surmountable. ECB President Mario Draghi, himself an Italian, succinctly summed these up in June: “‘[Mini-BOTs]’ are either money and then they are illegal, or they are debt and then the stock of debt goes up.” (EU law prohibits the creation of parallel currencies.) Defenses and counterarguments presented by proponents of mini-BOTs miss the point; on matters of European law, the only judgments that matter are those of the EU institutions.

Most Italian politicians still advocating mini-BOTs surely understand this and are trying to convince not EU officials but the Italian public that their plan is sound. It’s not going well. In the most recent Eurobarometer survey, in October 2018, 65.5 percent of Italians said the euro was a good thing for Italy (when undecided and neutral responses are removed). This was the highest level of support for the euro among Italians since the EU began systematically asking the question in 2013, and comparable to slightly differently worded questions from before the eurozone crisis. A July 2018 survey for Sky Tg24 found support for the euro at 74 percent, and a survey in May 2019 by the Italian Center for Electoral Studies at the University of Florence found 67.5 percent want to keep the euro.

Public opinion matters because the decision to leave the euro, or to take action that could force the country out of the euro, would be so economically, politically and socially disruptive for Italy that it is unlikely a government would move ahead without consulting the public, whether via a public referendum or a general election where the parties clearly state their intention. And even in the League party, the most anti-euro of the major parties, support for leaving the euro was at less than a third according to the Sky Tg24 poll. Indeed, this is why Salvini has consistently downplayed his party’s interest in leaving the single currency, saying instead that the League wants to change EU rules on spending from within. (Salvini has been more ambivalent on mini-BOTs; he has repeatedly said the government is open to alternative ideas, though his close adviser Giancarlo Giorgetti said last week that the parallel currency idea was “implausible” – a significant shift.)

The time may come when Italy can no longer afford the status quo, when things have gotten so bad that the chaos of an “Italexit” – default, a massive banking crisis, corporate failures and skyrocketing unemployment, a hyperinflating new currency, and possibly even the credible return of the northern secessionist movement – wouldn’t look so bad. But Italy is not there yet.

Waiting Game

At the same time, neither is the European Union closing in on imposing fines on a member state for the first time. An overlooked aspect of the excessive deficit procedure is that even if one is triggered, the decision to impose fines is at the discretion of the EU. In summer 2016, the European Commission determined that the Spanish and Portuguese governments had failed to take effective action to address their excessive deficits. Yet in both cases, the body canceled the fine, which could have amounted to as much as 0.2 percent of the offending state’s GDP.

Aside from the fact that a fine isn’t going to make a country like Italy’s fiscal situation any better, the biggest danger is the potential of creating a rally-around-the-flag effect that strengthens the forces the EU is trying to defeat. More likely, the EU will use the threat of an excessive deficit procedure (and, if needed, ambiguity about the fines) to worry investors about Italy’s economic future. Besides the importance of credit ratings, greater uncertainty pushes the spread between Italian and German bond yields higher. During last year’s spat, the spread on 10-year bonds reached 340 basis points. Credit Suisse has estimated that a spread above 400 basis points would be unsustainable for Italian lenders, eating away at capital buffers, raising private borrowing costs and damaging profitability. And it isn’t only the banks that are hurt; the European Commission’s June 5 progress report noted that because of the elevated spreads, the Italian government’s interest expenditure in 2018 was 2.2 billion euros (more than 0.1 percent of GDP) higher than it had projected in its 2018 spring forecast.

None of this changes the fact that Italy’s debt and chronic stagnation are a huge problem for Italians and for the eurozone. Eventually, Italy will be caught up in (or cause) a wider slowdown, and even in the most optimistic scenario it will not have much more fiscal space than it has now. One of two things will have to happen: Either Rome implements difficult structural reforms, possibly as part of a bailout or debt restructuring deal, or it will have to leave the currency union, potentially bringing the whole thing down on its way out the door. It is hard to calculate what that exit would entail, but it is the sort of decision whose results would likely be so chaotic and debilitating that no government – even one that pretends to be as confrontational as this one does – would go through with it while alternatives remain.

Ryan Bridges
Ryan Bridges is an analyst at Geopolitical Futures. Before joining Geopolitical Futures, Mr. Bridges worked as an editor at Stratfor for seven years. His focus is on Europe, where he has traveled extensively. He earned a bachelor’s degree from the University of Texas, where he studied political science with a minor in philosophy. He speaks some German.