The Italian Parliament has the full sovereign power to decide taxes and expenditure, but power also means responsibilities

March 26, 2020
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There is a widespread impression that the rejection by the Commission of the initial budget proposed by the Italian government in October contributed to the renewed increase in the risk spread on Italian government bonds.  However, there is no real reason for such a link.

If one looks closely that what the European Union can do one must conclude that it is ‘paper tiger’, in the true sense of the word: all the EU can is to send letters and admonitions to Rome.

For the time a confrontation looks likely. There is of course still the possibility that the Italian government changes its plans and tries to achieve a compromise. But if this does not happen the Commission will have to propose to the ECOFIN Council (the Group of finance ministers) to open a procedure for ‘excessive deficit’.  However, this procedure is in reality toothless.  There will probably be various recommendations addressed to Italy.  But in the end, the worst result would a fine, which would take the form of a relatively small (0.2 % of GDP) non interest bearing deposit.  But the drafters of these provisions did not anticipate today’s financial market conditions. A ‘non interest bearing’ deposit in an era of negative rates could actually be an advantage.

There is a fundamental difference between the rules on deficits and debts and some other policy areas, like competition policy and state aid rules.  For example, the Commissioner responsible for competition would have to vet any rescue plan for Alitalia.  The Italian government is thus not free to decide how to rescue the loss making flag carrier.  If the Commission objects to a rescue plan for Alitalia the Italian government cannot just proceed anyway (as it has done for the budget).  If the Italian government were to provide what the Commission considers illegal state aid, the Commission could take the country to the European Court of Justice, which would then quickly issue a formal injunction to Italy to desist.  At this point the Italian government would have to do what the Commission says.  No Member State has ever ignored a formal judgement of the ECJ.

There are thus some policy areas where Member States are no longer sovereign to do what they want.

But fiscal policy is not one of these areas.  The Treaty does not foresee for the fiscal rules the same enforcement mechanism which exist in areas where the EU has competence (competition policy, state aid control, trade policy, etc.).  The reason for this is simple.  It is called ‘no taxation without representation’. Political representation is still at the national level. This is why national Parliaments remain sovereign in their budgetary decisions.  All the EU can is to recall the commonly decided rules.

This is also the reason why the ratings agencies base their judgement not on what Brussels says or does, but on the actions and intentions of the Italian government and the political parties which support.  For example, the executive summary of the reason for the downgrade of Italy’s rating by Moody’s of October 19th does not even mention the ongoing confrontation with Brussels. Moody’s just sees a material weakening of the fiscal stance and worse growth prospect because this government does not intend to pursue any structural reforms.  The ratings agencies are implicitly arriving at a similar conclusion as Blanchard and Zettelmeyer who classify the Italian budget as a “Contractionary Fiscal Expansion” because the contractionary impact of higher interest rates is likely to outweigh the expansionary impact of higher social transfers.

The other two ratings agencies did not downgrade Italy, but used similar arguments as Moody’s, again without basing the judgement about the conflict over the Stability Pact.   One can certainly doubt the quality of the ratings, but they have an influence on markets.  However, it would be a stretch to argue that the EU can put pressure on the country via the ratings agencies.

The conclusion is that Italian fiscal policy is ‘made in Italy’.  The Italian Parliament has the full sovereign power to decide taxes and expenditure, and also to ignore rules which itself has accepted with a very large majority a few years ago.  But power also means responsibilities.  The large public debt which is weighing on the country today is the cumulated result of many sovereign decision taken by Italian governments and Parliaments in the past.  It will not be the responsibility of Brussels, but only of Rome if the growth does not pick up, the risk premium increases further and the country is thrown in another crisis.