Either Italy or Europe is going to have to yield

Italy has not backed down from conducting a highly expansionary fiscal policy, with the coalition government intent on delivering on its promises . This has given rise to a dispute with the European Commission, which is asking Italy to respect its European commitments o n budgetary matters. As a result of this dispute, Italian interest rates have risen sharply, Italy’s credit rating has been downgraded and the rise in government bond yields is triggering a crisis in the banking system. The Italian government probably thinks that the euro zone’s fiscal rules will be relaxed after the European elections and that the ECB will intervene if yields on Italian bonds rise too much. If the Italian government is mistaken and if Europe (the Commission, the ECB) does not yield, the rise in interest rates and the banking crisis will force the Italian government to reduce its fiscal deficit. If Europe does give in , Italy’s fiscal deficit will become very high. But Europe is very unlikely to yield: Many countries (Germany, the Netherlands, Austria, Finland, etc.), even those with so-called “populist” governments, are completely opposed to fiscal laxity; The ECB has no instrument to drive down Italian interest rates: quantitative easing involves purchase of all government bonds , while the OMT would require Italy to be under a European programme (which would mean fiscal deficit reduction and structural reforms), which would be unacceptable for the Italian government; An ESM loan would also require Italy to be under a European programme; Italy has no credible threat, as an exit from the euro would ruin the country; Italy’s fiscal deficit is not helping to resolve the country’s structural problems.