How Italy Sparked a Standoff Over EU's Budget Rules

(Bloomberg) -- For nations of the European Union’s single currency area, the annual budget process isn’t over once their spending plans are drawn up. The European Commission also gets a say. In Italy’s case, the response from Brussels was unprecedented. The EU executive arm rejected its budget on Oct. 23 and told the government in Rome to revise and resubmit it within three weeks. With no evidence that Italy is willing to reconsider its plans to spend big, signs point to an escalating standoff.

1. Why does the EU have a say on a member nation’s budget?

EU countries have to follow a set of fiscal rules spelled out in what’s called the Stability and Growth Pact. Focusing on deficit and debt, the rules are designed to force members to maintain sound public finances and coordinate their spending policies. Monetary policy is the responsibility of the European Central Bank, and matters such as taxation are up to each country. But the EU expects its 28 member states to heed the economic stability of the region as a whole.

2. What are the EU rules?

No country should have a budget deficit larger than 3 percent of gross domestic product or debt above 60 percent of output, and governments must set annual targets to show they’re moving in the right direction. The EU made the rules for euro-area countries stricter in 2013 following the sovereign debt crisis, which brought some member economies including those of Greece and Portugal to the brink of collapse and needing bailouts. The updated rules require euro-zone nations to pursue a balanced budget by law, a step aimed at keeping mounting public debt in check.

3. How are the rules enforced?

The European Commission, the EU’s executive arm, monitors the finances of member states, reviews annual spending plans, identifies imbalances and issues country-by-country recommendations every spring. These have to be endorsed by finance ministers and incorporated into the budget plans for the subsequent year. The Italian government’s decision not to back down despite warnings by Brussels made the commission issue a negative opinion on Italy’s budget, essentially rejecting the country’s spending plans -- something the commission has never done before.

4. Who has a problem with the EU rules?

France, Belgium and Spain are among the countries that have received warnings or reprimands from the EU in recent years, though never a formal rejection of their draft budget plans or any financial sanctions. Italy at the moment is the nation in the EU’s crosshairs. In a showdown that was building for weeks, the European Commission on Oct. 18 declared Italy’s spending plans to be excessive. Italian leaders have spoken of wanting the commission to tweak how it calculates deficits.

5. What exactly is Italy seeking to do?

Its budget calls for a deficit equal to 2.4 percent of gross domestic product, compared with a 0.8 percent shortfall planned by the government that was swept out of power in March. This first budget plan by Italy’s coalition government of two populist parties makes assumptions about economic growth that Italy’s own budget watchdog considers overly optimistic. It proposes accepting a wider deficit as the cost of delivering on election promises that include a “citizen’s income” for the poor, tax cuts and a lower retirement age. Under Italy’s plan, the so-called structural deficit -- a key measure for the commission, since it strips out effects of the economic cycle and one-time spending items -- is projected to increase by 0.8 percentage points, far from the 0.6 percentage-point reduction that Brussels wants.

6. What happens to a nation that breaks the EU rules?

While Brussels ultimately has no real power over national budgets, governments are expected to take the commission’s opinion into account and avoid a reprimand that could affect financial markets. That’s because a negative assessment by the commission of a spendthrift government’s budget plans could impact investment decisions and push up countries’ borrowing costs. If the commission finds a country persistently breaks deficit rules, it could eventually open a so-called excessive deficit procedure -- a process where the country has to reduce its deficit by a set deadline or risk sanctions of up to 0.2 percent of output. For Italy, that step would be several months down the road. The EU’s enforcement credibility has come into question, such as when it opted not to penalize repeat offenders Spain and Portugal in 2016. France, too, has received leniency over the years and Germany, Europe’s biggest economy, went unpunished when it broke the rules.

The Reference Shelf

©2018 Bloomberg L.P.