The budget standoff between Italy's anti-establishment government and the European Commission has rattled markets and brought back memories of the eurozone sovereign debt crisis. EU officials should remain open to unconventional economic-policy approaches, and the Italians should show that they are serious about long-term reforms.

PARIS – Global markets, policymakers, and risk managers are watching the budget skirmish between Italy’s government and the European Commission closely. The episode highlights a growing tendency among governments in both advanced and emerging economies to question economic policy orthodoxy. As this trend intensifies, economists and market participants need to think harder about, and communicate much better, the implicit tradeoffs of conventional economic and financial policymaking under challenging circumstances.

Having been elected with a mandate to promote faster, more inclusive growth, the Italian authorities are pursuing a more expansionary fiscal stance. Their budget, however, has been “rejected” by the European Commission for its “non-compliance” with EU deficit rules. As a result, Moody’s has since downgraded Italy's sovereign credit rating to just one notch above junk level, citing worries about the country’s debt stock and the government’s overoptimistic growth projections.

With Italy’s leaders insisting that they have “no Plan B,” spreads on Italian government debt have risen back to levels not seen since the dark days of euro crisis. And as both public- and private-sector borrowing costs increase, some observers are starting to worry about the implications for the Italian financial system. In fact, some have even gone as far as to argue that Italy poses an existential threat to the eurozone. Others, however, dismiss this as dangerous hype, given that Italy still has a manageable short-term debt-servicing profile, a primary budget surplus and a current-account surplus, as well as considerable economic potential.

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