The European Commission (EC) has distractions other than Brexit to contend with.

On
Wednesday, November 21st, 2018 it begun formal proceedings against the Italian government
over its planned budget for FY 2019.
Despite the request for a revision to the original high borrowing and spending plan,
Rome refused to make any alterations. That stubbornness has placed the EC and Italy on a
collision course that may result in  serious monetary sanctions being applied from Brussels.
Italy’s outstanding government debt : GDP has risen from 102.4% in 2008 when the
global financial crisis began to 133.1% at the end of June this year. The Italian economy
advanced by just 0.8%  year-on-year in Q3 2018, slowing from a 1.2% level of expansion in the
previous three-month period. It was the weakest growth rate since Q2 2015.
The Italian economy was hit hard by the 2008 global financial crisis and the subsequent
recovery has been tepid. The level of debt : GDP rose after the crisis even with austerity
measures being introduced. The weak economy and its impact on households has, together with
the recent migrant crisis, fueled the support for the anti-establishment parties.
The coalition that formed a government after elections in March 2018 comprises the far-
right League party and the anti-establishment Five Star Movement. Both made incredible
pledges during the campaign to turn their back on austerity and undertake the introduction of a
universal basic income, a substantial reduction in taxes and the retirement age.
Italian Economy Minister, Giovanni Tria, has said that the “citizens’
income”would help manage the social consequences of technological change and declared
that allowing people to retire earlier would give firms a younger, more dynamic and skilled
workforce. A point not without some merit given that youth unemployment in Italy increased to
31.60% in September from 31.30% in August.  For comparison, youth unemployment in the
Eurozone overall remained unchanged at 16.80% in September from August.
Until the coalition was formed the financial markets had been happily buying Italian
debt. This took the spread of the 10-year Italian paper over the German equivalent to a relatively
narrow 116.5bps. However, once the coalition was formed, and being mindful of the election
pledges made the spread began to widen and at 12:25 GMT on November 22 nd, 2018 the spread
was out to 306.4 bps
Clearly capital markets are losing faith that Mr Tria can keep a strong grip on Italian
finances. His message from September 20th seems extremely hollow now.
“…We are working on a mix of policies that show
everyone they should have confidence in Italy, not only in
our public finances but in our economic growth,…”
The original FY 2019 budget proposition was published in September and as one dug
into the detail, they implied Italy would run a budget deficit of 2.4% for the next three years even
with the government’s optimistic growth forecasts.
 Not only was the coalition marking a departure from austerity it was charting a
completely new course from that plotted by the previous centre-left administration of Matteo
Renzi. That administration had targeted a deficit of just 0.8% of GDP in 2019 and a balanced
budget in 2020.
Why is the EC so determined that Italy should amend its budget? The answer to this is
found in the fact that the EC, just like the European Central Bank (ECB), ironically run by an
Italian, Mario Draghi, regard the Italian budget draft to be non-compliant with the fiscal rules of
the European Union (EU) and Eurozone. They cannot condone the Italian proposal to pursue a
programme of excessive debt.
Mr Tria has issued warning to the EC against “pointless” quarrels over Italy’s
fiscal plans having stated that financial market stability was a pre-requisite for boosting the
economy. That is rich given the aggressive fiscal expansion he is proposing. If he thinks the ECB
will provide a bid of last resort, he will be in for a rude awakening
Herein lies the problems facing the entire European project.
Firstly, the United Kingdom did the unthinkable and opted to leave the EU. That is not
going so well.
The EC has stated that Italy, like all other members of the EU and Eurozone has the
right to choose its budgetary priorities. However:
“…The role of the Commission is to assess whether Italy
fulfils the fiscal commitments that it has itself taken before
the other member states. …”
So far, the signals are that Italy will stick by the pledge to hold fast to its spending
plans. The coalition are placing a huge bet on the borrow-and-spend policy delivering an
enormous fiscal multiplier to boost economic growth and employment, and so despite a rising
debt burden the debt : GDP ratio will fall.
That assumption is at odds with recent empirical evidence as any benefit to the Italian
economy has been consistently worse than those seen in Germany, France and Spain. Indeed, in
the ECB Working Paper #1760 of March 2015 the evidence suggested that in the Italian case
short-run multipliers were in general negative.
On November 21, the European Commission announced that sanctions against Italy
over its budget were now "warranted". They have already warned that the current cost of
servicing Italy’s debt burden is EUR65 Billion (USD74 Billion), more than is spent on
education.
That debt service cost will rise and Capital Economics forecast that the yield on the
Italian 10-Year government bond will rise from 3.432% this morning to 3.500% by year end and
hit 4.000% during 2019.
Capital Economics said if Italy were to introduce the planned budget for FY 2019 in full
it would cost EUR67 Billion (USD76 Billion) and bring the deficit to 6.2% of GDP
 Supporting the findings of the ECB and Capital Economics Valdis Dombrovskis, the
EC’s Vice President for the Euro said:
"…The impact of this budget on growth is likely to be
negative in our view. It does not contain significant
measures to boost potential growth, possibly the opposite, …
With what the Italian government has put on the table, we
see a risk of the country sleepwalking into instability. …"
Pierre Moscovici the European Commissioner for Economic and Financial Affairs,
Taxation and Customs said there are unsolved doubts about increasing debt:
"…Who will pay the bill for this extra spending? We
continue to believe that this budget carries risks for Italy’s
economy, for its companies, for its savers and for its
taxpayers…”.
The Italian government defends its plan saying it would boost the economy, despite the
economic forecast provided by the Commission pointing toward a lower growth trajectory.
The hard, cold truth is that should the Eurozone economy turn sour, a member the size
of Italy, (3rd largest economy), with the world’s fourth largest government debt, poses a real risk
for the stability of the EU and the Eurozone.
This is going to be a recurring pressure point throughout next year. Brexit, may prove to
be a minor issue compared to an Italian incendiary.