In late October, Italy’s populist government finally got its showdown with Brussels. In September, Italy’s powerful deputy prime ministers, Lega leader Matteo Salvini and Five Star Movement leader Luigi Di Maio, agreed on a draft budget calling for tax cuts and a minimum income for the unemployed, both of which would increase Italy’s deficits at a time when Brussels is pressuring Rome to reduce its debt load. Now Salvini and Di Maio expect European institutions to make concessions instead. It is hard not to imagine that this was their plan all along.

Salvini and Di Maio know that the European institutions will have to push back on any attempt to break the rules for macroeconomic policy coordination across countries—and specifically those rules that force Italy to rein in its debts and deficits. In turn, Salvini and Di Maio plan to argue that Brussels is preventing them from fulfilling their democratic mandate.

This kind of rallying cry will play well in the run-up to the May 2019 elections to the European Parliament. The danger is that it will play badly in financial markets. If market participants start to worry that Italian public debts will begin growing again, they will become less willing to lend to the Italian government, and every Italian will find it more expensive to borrow. This could create a self-fulfilling dynamic leading Italy back into crisis, particularly if the government’s policies undermine confidence in the country’s banks. Hence the European Commission (EC) must seek to enforce the rules—not just for their own sake but to safeguard the European economy as a whole.

ITALIAN STANDOFF

The showdown between Brussels and Rome began in earnest on October 18, when European Commissioners Valdis Dombrovskis and Pierre Moscovici sent a strongly worded note to the Italian government making clear their “serious concern” about the budget’s “significant deviation” from Italy’s prior commitments to lower its debt and deficits. Usually, such a letter would prompt the start of negotiations between the EC and the national government in question. Instead of offering to make concessions, however, Italian Economics and Finance Minister Giovanni Tria responded on October 22 that although Italy’s budget is “outside the norms” for European policy coordination, the Italian government does not believe that its proposal constitutes a financial risk. In fairness, Tria initially wanted to go the usual route of negotiating concessions. But Salvini and Di Maio would have none of it.

The next day, the EC published its official opinion, stating that the Italian budget is in “particularly serious non-compliance” with Italy’s EU obligations and requesting that Italy submit a revised budget within three weeks. The commission repeated the code words “significant deviation,” which point to accelerated disciplinary procedures. (The usual procedures for pushing back against “excessive deficits” are time-consuming; the special procedures for sanctioning “significant deviations” are quicker.) These procedures could, depending on how they are interpreted, lead the EC to demand that the Italian government place an amount equal to 0.2 percent of Italy’s gross domestic product—or roughly $4.5 billion—into a non-interest-bearing account, which the Italian government would forfeit if it continued to hold out. Effectively, the EC threatened a sanction.

Salvini and Di Maio were quick to denounce the EC’s opinion as an insult to the Italian people and Italian democracy. As for the threat of sanctions, Salvini has suggested, the EC can demand all the money it wants, but it cannot come to Italy and get it.

REBELS WITH A CAUSE

Salvini has a point. Enforcement is not a strong suit in European macroeconomic policy coordination. The EU’s disciplinary procedures exist to ensure that decisions are made in a timely manner and in accordance with countries’ European commitments. They were designed to prevent negotiations from dragging on too long, not to punish outright noncompliance. In that sense, the threat of sanctions has always been a paper tiger—an excuse that national politicians can use to explain to their domestic audiences why they are making concessions to Europe.

There have been times, of course, when national politicians have rejected European recommendations about their national budgets altogether. The Irish government did so in 2001; the French and German governments followed suit two years later. In these cases, the EC more or less looked the other way. That is why the threat of sanctions is now more prominent; it is also why the procedures move more quickly than they did in the past.

Nevertheless, the procedures still largely assume that once the EC renders a decision, national governments will play along. The only exceptions are those countries which depend explicitly on getting money from Brussels, either in the form of net subsidies above and beyond their contributions to the European budget or as some kind of a bailout package. Those countries risk having those funds taken away.

Salvini speaks to journalists in Lyon, October 2018. Emmanuel Foudrot / Reuters

Italy does not depend on Europe for its finances. Although many of Italy’s regions receive important European subsidies, the government as a whole is a net contributor to European coffers. According to the European Parliament, Italy contributes $15.9 billion to the EU while receiving only $13.2 billion in support for agriculture, basic research, and regional development. Moreover, the European budget for the next seven years is currently under negotiation, and Italy’s net contribution will have to increase if the EU is going to maintain its budget size after the withdrawal of the United Kingdom. Therefore, Brussels would have real leverage over Rome only if Rome were forced to ask for a bailout.

From this perspective, the conflict between Italy and the EC has evolved into something like the game of chicken in the film Rebel Without a Cause, in which Buzz and Jim speed their cars toward a cliff. The first one to back down is chicken; the other gets to go out with Judy. The EC is hoping that market pressure on Italy will increase enough to force Rome to comply with European procedures before the EC has to try to impose a sanction that it cannot enforce; the Italian government is betting that it can hold out long enough for Brussels to concede the weakness of its position and back down.

A ROCK AND A HARD PLACE

Unfortunately for both Italy and the EC, the whole lesson of Rebel Without a Cause is that it is better to avoid such conflicts altogether than to pursue them. In the movie, Buzz goes over the cliff, devastating both Jim and Judy. All sides in this conflict have to be acutely aware that it can end badly.

The problem for Salvini and Di Maio is that they cannot achieve their joint political program without increasing deficits. Salvini has to deliver tax cuts to his constituents in northern Italy and to live up to his promise to undo the country’s recent pension reforms. Di Maio has to ensure that his constituents get a livable pension and a basic minimum income. Moreover, the two sides of the coalition have conceded about as much as they can manage. Salvini’s followers hate Di Maio’s basic minimum income; Di Maio’s followers hate Salvini’s tax amnesty. Neither side can cede ground on its preferred policy commitments without forcing the other to do so as well. Even finding a balance was difficult; striking a new one would be even more so. The two leaders would rather try to exploit the EC’s weakness than risk a breakup of their own coalition government.

The problem for the EC is that now it plays the central role in the EU’s macroeconomic policy coordination procedures. Originally, those procedures centered on the Council of Ministers (now called the Council of the European Union), where member state representatives had to make a political decision to impose the EC’s recommendations on a recalcitrant member state. Since 2013, however, the EC’s recommendations are binding unless the Council of the European Union makes a political decision to set them aside. That change was made to strengthen the EC. In fact, the change has exposed it. Previously, other member states were responsible for cajoling one another into compliance or making exceptions. Now the EC is the lightning rod for any member state government that is unhappy with the way the procedures are applied.

The official rumor is that every other country in the EU is lining up with the EC against Italy. That may be true on the surface, but it is less convincing underneath. Some governments, such as those in Germany and France, are almost sure to be looking for some form of face-saving compromise. They have important agendas for reforming European institutions and for strengthening European policies, and they have pressing domestic problems from which conflict with Italy is a distraction. For others, such as the Dutch government, the situation is different. It has a one-seat majority in the national parliament. The Dutch prime minister, Mark Rutte, faces staunch opposition to his right, and he already made and then broke a commitment to voters not to compromise at the European level over a third Greek bailout. Rutte cannot afford to see the EC back down, and he will be looking for European support to prevent that from happening.

FROM BAD TO WORSE?

In Rebel Without a Cause, the audience knows that Buzz will drive over the cliff because it can see that his jacket sleeve is tangled up in the door handle, preventing him from jumping out of the car in time. In the conflict between Italy and the EC, the tangle surrounds the Italian banks. Those banks have taken a beating in the markets since the current Italian government came to power. They are subject to further losses as downward market pressure on Italian sovereign bonds eats away at their regulatory capital.

Salvini and Di Maio have promised that no bank will be allowed to suffer. More important, European Central Bank (ECB) President Mario Draghi made it clear last Thursday that his institution can do nothing to save the Italian banks unless the Italian government agrees to go into a bailout program, as Spain did in 2012. Salvini and Di Maio have said that this is not going to happen. Di Maio has gone further, criticizing Draghi personally in an effort to drag the ECB into the conflict. If he succeeds, he may make it harder for the ECB to step in should that become necessary.

There are many ways that this could end badly. The EC could rush its procedures and then come up empty-handed if the Italian government refuses to cooperate. This would deliver a powerful blow to European macroeconomic coordination, both because it would make it obvious that countries can break the rules with impunity and because it would make it harder for countries such Germany and the Netherlands to adhere to a common European framework.

There is also the chance that Italian politicians could be so focused on winning their battle with the EC that they will wait too long to shore up investor confidence in Italian sovereign debt markets and prop up Italian banks. Italians have plenty of savings to cover their government’s public debts, but it is hard to see how the Italian economy could grow if those savings are diverted away from investment and into servicing debt. Italy’s banks are weak because of the last downturn; another one will only do more damage. Moreover, the instruments that the Italian government has to shore up the banks would likely drag it into even more conflict with Brussels and with the ECB.

The worst of all worlds would be to see these two developments happening together. In that scenario, Europe refuses to prepare for the financial crisis that the collapse in market confidence toward Italy and Italian economic performance engenders. This is the scenario in which both the EU and the Italian government drive off the cliff. It is an unlikely outcome for now. But it will remain unlikely only if the two sides work to defuse the conflict between them.