For a brief moment on Tuesday, it looked as if the populists running Italy's government had finally blinked in their monthslong budget standoff with the European Commission. Deputy Prime Minister Matteo Salvini, who is effectively running Italy's government along with fellow Deputy PM Luigi Di Maio, suggested that Italy could back off its 2.4% deficit target, so long as all of the fiscal stimulus promised by their government could be preserved.
But after meeting Monday night with Prime Minister Giuseppe Conte to discuss the country's response to the Commission's unprecedented rejection of Italy's budget (as well as its decision to recommend an "Excessive Deficit Procedure") Salvini and Di Maio clarified on Tuesday that any reduction in the deficit target would be minimal - 20 or 40 basis points on the outside, keeping it well above the Commission's recommendation for a 0.8% deficit. For Italian bondholders and those who own Italian bank shares, this is certainly unwelcome news, evidenced by a flattening yield curve on Tuesday as bonds reversed some of their gains from the day before.
And as Italy digs in its heels, its European peers have endorsed the EC's plan to punish the Italians. According to Reuters, delegates with the European Economic and Financial Committee have endorsed a draft letter signifying their support for the EDP. While the statement could still change, the delegates are expected to formalize it during a Thursday meeting.
"Overall, the Committee is of the Opinion that...the debt criterion should be considered as not complied with," the draft document said.
"A debt-based EDP is thus warranted," the document concludes, referring to the EU disciplinary process known as the Excessive Deficit Procedure.
An EU official said the draft was still subject to changes, but its conclusions were not contentious.
To be sure, the delegates aren't responsible for making the decision to embrace the EDP. That must be left to the Eurogroup, which is expected to meet on Dec. 3 to discuss the issue, and again in January (these are regularly scheduled meetings). A majority of eurozone states must vote to pursue sanctions for the proceedings to move forward. It's unlikely that the Eurogroup would opt to move forward in December. Rather, most analysts see January or February meetings as more likely. The group has until Feb. 15 to make a decision. If the decision is delayed until February, Italy would receive something of a reprieve because the group would likely need to wait until after European elections in May to follow through with imposing the sanctions (though the four month time limit on the Eurogroup's endorsement still stands).
Once approved, fines under the procedure could start at 0.2% of Italy's GDP, which would measure in the billions of euros. Though it's difficult to imagine how this will help prevent the Italians from "sleepwalking into instability", as the EU has warned. Any fine would be unprecedented: Eurozone rules allow for budget deficits of up to 3% of GDP, which is actually more than what the Italians are planing. However, those same rules also require national debt burdens not to exceed 60% of GDP. Italy's debt burden is a staggering 130% of GDP, the second highest in eurozone. The EU made allowances for Italy when it first joined the euro in 1998 under the condition that it would work toward reducing its debt burden. By blowing out its deficit, Italy risk violating its pledge to reduce its debt.
Commission member Pierre Moscovici confirmed on Thursday that the commission is continuing to dialogue with the Italian government, but hasn’t changed its view on the 2019 budget. Moscovici added that the budget is a danger to the country's economy and savers.
"The risk has a name: Italian debt," he said during a talk in Paris. "The interest for everyone is for rules to be respected. These rules are neither rigid nor stupid," he said. He added that a rapproachment is still possible if Italy embraces "imaginative" and "positive" solutions that would allow it to respect European rules.
The populists argue that Italy has run a primary surplus almost every year since 2000, and that its debt load pre-dated its membership in the euro. ECB stimulus helped the country recover from the 2011-2012 debt crisis by lowering its interest payments, offsetting the most painful aspects of budget austerity, but now that interest rates are rising again, the populists believe they must act to save Italy's moribund economy with policies like tax cuts, higher pension benefit and payments of up to 780 euros a month for poor Italian families.
But whatever happens, many steps remain in the process. If the EFC approves the draft statement tomorrow, the process will move to the second rung of the latter below: