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This past week the game of brinkmanship between the European Union and Italy escalated to a whole new level. The EU retaliated by rejecting the Italian national budget in an unprecedented move. The Italian populist government responded by doubling down. This troubling game of chicken is now threatening (not only the European Union economy but also) the entire world economy as the populist government refuses to give in to EU demands to reduce their spending plans.
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The EU Actually Rejected A Country's Budget?
For years analysts have idly speculated on what might happen someday if the European Union actually challenged one of the countries on its own national budget. Now that the Euro-skeptic Italian populist government has defied Brussels, you know the answer. Either the EU or the Italian government will have to back down eventually, but so far neither party is inclined to compromise and lose face. Neither the Italian government nor the EU can afford to look weak.
Last Tuesday the European Union actually made good on its increasingly vocal threats of the past and took the unprecedented step of rejecting a member nation's budget. Their argument was that Italy's new budget went against the fiscal laws of the EU block and threatened Rome's public finances with unacceptable risks. This highly irregular move by Brussels has created chaos in the euro zone in the aftermath as Italy refuses to back down.
Over the short run at least, the budget would boost the amount of Italy's deficit and total government debt. Analysts have determined that this would grow the Italian deficit to potentially 2.4 percent of the GDP in the upcoming years. Technically the EU rules allow a country to go higher than this. The problem is that a past technocratic Italian government agreed to a maximum deficit amount of .8 percent of Italian GDP.
Meanwhile, as this chart below shows, the French can run more pronounced deficits than Italy and get away with it:
Italy refusing to comply left the EU with little choice in their minds. Brussels had warned Rome repeatedly that it would need to cut deficits in the 2019 proposed budget in order to avoid punitive measures of heavy fines from the block in early 2019. In true form, the popularly elected Italian government defied Brussels.
This earned them great popularity ratings with the Italian people who are tired of EU rules and regulations that do not deliver prosperity to Italy. Unfortunately for them, the EU sees a government debt in Italy of 131 percent of the entire national output. This turns out to be over twice as much as the euro zone allows by law.
The Animosity Between Brussels and Rome Ominously Grows Dangerous
The Executive arm of the European Union is the European Commission. They informed Italian lawmakers and the ruling triumvirate of Prime Minister Giuseppe Conte, Deputy Prime Minister Luigi Di Maio, and Deputy Prime Minister Matteo Salvini that they must revise the initial budget. The real danger is that according to the NY Times, the populists are digging in now.
The Vice President for the Euro (and Social Dialogue) Valdis Dombrovskis of the European Commission issued a press statement from Strasbourg. They found no choice but to reject the present Italian budget proposal in favor of the government coming up with an alternate plan, as Dombrovskis stated:
“Unfortunately the clarifications were not convincing to change our earlier conclusions of particularly serious non-compliance. The Italian government is consciously and openly going against commitments made. Breaking rules can appear tempting at first look, it can provide an illusion of breaking free. It is tempting to cure debt with more debt, but at some point the debt weighs too heavy.”
This commissioner furthermore declared that Italy now runs a significant risk of a debt trap. He pointed out that back in 2017, Italy spent the same sum of money in servicing its debt as on education. Regardless of this point, this is the first instance where the EU overshadowed an independent member country through rejecting its budget.
The matter now stands with Italy having to come up with a new budget document within three weeks. An alternative is a huge fine that Rome will be forced to pay. The euro has dropped several cents against the dollar since the struggle intensified in the past week.
Italians Refuse to Take The Rejection Sitting Down
Italy's fiscal situation is not pretty. They boast the unenviable distinction of having the second biggest pile of debt within the entire euro zone. It amounts to a staggering $2.6 trillion (or 2.3 trillion euros). In the European Union, the member nations can not run yearly deficits in excess of three percent of their annual GDP.
Yet you can not tell the still-new Italian populist government this. The coalition that entered power after the March elections is seeking to spend far more money on investment to fulfill their campaign spending pledges. The Italian Deputy Prime Minister Luigi Di Maio from the Five Star Movement declared this reaction from Brussels to be no surprise.
He then turned it around, arguing that Italy could no longer follow the failed prior policies that forced austerity and lowered fiscal spending. In a parting salvo from his comments, Di Maio insisted that the EU Commission start treating the Italian people and government with some respect.
Goldman Sachs Enters the EU Versus Italy Budget Battle
All that the volatile situation was missing is a prominent global investment banking analyst taking sides. Now Goldman Sachs has provided that. Just before Brussels issued its stinging rejection of the Italian budget, Goldman weighed in with their opinion that the volatility in Italian markets over the last few months has created a bear market in the nation's bond and stock markets and will likely get worse.
Goldman pointed out that already the Italian bond yields have skyrocketed up to their highs from the last euro zone crisis back in 2012. According to Economist Silvia Ardagna of Goldman Sachs:
The market scenario in Italy “may need to get worse before it gets better.” The Italian government will not back away from the battle lines with Brussels unless it has powerful motivation. A possible motivator could be still- greater market correction.
Unfortunately This Stalemate Is Causing Real Economic and Financial Markets Consequences
The drama may make for good prime time news coverage, but it has real-world consequences for economies far beyond Italy and even the European Union. Investors have taken this great “constitutional crisis” between the EU center and national countries and added it to the Brexit stalemate to draw the uneasy conclusion that still more geopolitical and economic instability across Europe is all too likely. Benchmark 10 year Italian bonds quickly topped 3.59 percent in the aftermath of the budget fray.
Now investors and currency markets have drawn the conclusion that the ECB European Central Bank may not have the latitude to actually raise euro zone interest rates this coming summer. This sentiment has driven the euro down to as low as 1.13 in recent Forex currency market sessions. As Italian stocks at the FTSE MIB have plunged, this has impacted other European exchanges and also roiled U.S. financial markets from time to time.
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