These are unprecedented times in Europe. The EU is still engaged in unprecedented exit negotiations with the United Kingdom. Less than a year ago, the European Commission took the unprecedented step of triggering disciplinary measures against Poland, and last month the European Parliament triggered the same so-called Article 7 proceedings, this time against Hungary. Then on Tuesday, the European Commission rejected the draft budget of a member state – Italy – for the first time ever.

Though Italy’s government is unabashedly populist and euroskeptical, there’s nothing unusual about an EU country flouting EU budget rules. What’s different this time is that the bloc feels compelled to defend the sanctity of its budget rules but can’t risk forcing out Italy, its fourth-largest economy (and after Brexit, the third-largest) and a founding member. Leaving would be a last resort for Italy as well. An Italexit would be extraordinarily painful for both sides – and it could be a mortal blow for the euro. Rome understands, however, that Brussels lacks the instruments to force compliance on its own. The real threat to Italy is that the EU will try to use market pressure to bend the government to its will.

This Could Take a While

Italy’s debt has been a problem for years, and the country’s nearly five-month-old government has aimed its spending plans at stimulating consumption to spur economic growth. The budget features a deficit for 2019 that is triple what the previous government had agreed to with Brussels and is unlikely to reduce Italy’s public debt – already the second-highest in Europe. It would also expand the country’s structural deficit (the nominal budget balance minus one-off expenses and business cycle effects) when, based on prior agreement, the new budget was supposed to decrease it. The commission’s rejection of the budget is just one step in a longer process; it merely extends a volley of submissions and rejections between the two parties that could last into early December. And although the Italian government must finalize and pass its budget by the end of the year, that doesn’t have to be the end either. In typical, tortuous EU fashion, the affair could easily drag out to the middle of 2019.

But the EU is in no mood to wait. It rejected the budget nearly a week before the official deadline for a decision, and EU officials have said they would also consider moving up a decision on whether to sanction Italy, something that otherwise would wait until more complete economic data becomes available in April. (EU rules permit the commission to fine member states that break budget rules up to 0.2 percent of their gross domestic product – a decent sum for Italy but not enough to force compliance.) The bloc is looking for any way to end this fight quickly and decisively. For Italy, on the other hand, a prolonged spat – particularly in which it’s defending the interests of its people – will only strengthen its euroskeptic government.

The EU’s best weapon, then, is one it can influence but that it doesn’t control: the markets. In a peculiar role reversal, it’s the EU that has been inciting investor fears lately. Last week, German news outlet Der Spiegel ran a report it later corrected that EU budget commissioner Guenther Oettinger said the European Commission, breaking protocol, had rejected the Italian budget out of hand, without giving Rome a chance to justify its plans. The next day, the commission sent a letter to the Italian government seeking clarification on the budget, which it called an “unprecedented” breach of EU rules. (The claim rings a little hollow; a 2.4 percent deficit wouldn’t even have cracked the eurozone’s top three last year, and France has run larger deficits for years with no penalty.) And on Thursday, European Central Bank chief Mario Draghi refused to be drawn in to mediate between his native country and the commission. Draghi, who vowed in 2012 during the eurozone crisis to do “whatever it takes” to defend the euro, warned the Italian government nearly two weeks ago that the ECB would not come to its rescue if budget talks with the commission failed. He also reaffirmed Thursday that the central bank would end its bond-buying program at the end of the year, a move that should enable yields on long-term government bonds to rise.

The strategy is clear: If the EU wants to push Rome to compromise on the budget quickly, without having to make a decision about sanctions, market anxiety is its friend.

And it has plenty of opportunities to turn up the heat. Eurozone ministers are scheduled to meet Nov. 5 and again on Dec. 3. The ECB’s Governing Council meets Dec. 13, and this year’s final EU summit is set for Dec. 13-14. Each of these meetings is a chance for the EU to draw attention to the supposedly reckless spending plans of the Italian government – not in front of its peers, but in front of investors.

Italy Bides Its Time

While the EU is emphasizing its differences with Italy, leaders in the country are going out of their way to downplay the dispute. Prime Minister Giuseppe Conte and his two deputies – the heads of the Five Star Movement and the League, the two parties in the governing coalition – have all said recently that Italy has no intention of leaving the European Union or the eurozone. (This despite the fact that the coalition’s first choice for finance minister was Paolo Savona, who has described the euro as a “German cage” and co-authored a paper in 2015 titled “Practical Guide to Leaving the Euro.”) Conte said the two sides would “sit down around the table and talk, just like any family would do” to resolve their differences over the budget. An undersecretary in the League, the party of outspoken Deputy Prime Minister Matteo Salvini, said over the weekend that the current 2.4 percent budget deficit was a “ceiling” that the government may not reach and warned that the 10-year yield spread between Italian and German bonds was a threat to Italy’s banks that could not be ignored. Salvini himself has hinted in the past that a spread exceeding 400 basis points could force the government to reconsider its spending plans, and Credit Suisse cautioned earlier this month that such a spread would be unsustainable for Italian banks.


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There’s still plenty of room for compromise. Italy wants to try to spend its way to stronger economic growth, as Portugal did a few years ago. The EU wants to look like it still has control over what its member states do. In a vacuum, the answer would be to revise Italy’s budget so that excess spending is directed toward things that, from Brussels’ perspective, will encourage economic growth and not “clientelism,” as the head of a German think tank described the goals of some parts of the budget.

Whether Italy would accept this solution is a different matter. The Five Star Movement won the general elections in March with nearly 33 percent of the vote. Since then, though, Salvini’s League has caught and surpassed its poll numbers to become the most popular party in Italy according to nearly every survey. It would be difficult for the Five Star Movement to concede on the more controversial parts of its plans, such as a costly basic income, without the League forfeiting something in return. The next major event in the saga comes Friday, when Standard & Poor’s will update its rating of Italy’s debt. Moody’s rating agency already dropped Italy a notch last week to Baa3 – just one level above junk status. At the time of writing, the spread for Italian bonds sits at 308 basis points, still below last week’s peak of 338 basis points, a five-and-a-half-year high.

The best-case scenario for the Italian government is that bond yields don’t skyrocket, it can draw out the dispute while continuing to act as the defender of Italy’s future, and it ultimately secures a very public victory over Brussels. But the EU wants to end this fight as soon as possible. If it actually has to decide whether to penalize Italy in the spring, it will have failed. Public opinion in Italy could shift toward a referendum on the euro, market anxiety could spread to states like Portugal and Spain, and the future of the single currency could come into doubt. Better to let the faceless market be the bad guy.