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Italy’s populist government and the European Union are at war.

The European Commission, the EU’s executive body, rejected Italy’s proposed 2019 budget on Tuesday, arguing that it posed unacceptable risks to both Italy and the EU countries that use the euro. It was the first time the EU has sent a national budget back for a rewrite and it has set the stage for a bruising battle that neither side will win.

The Italian government will use the EU’s rejection to score political points. The government, composed of the right-wing League – think of it as the Italian version of Marine Le Pen’s National Front party (now National Rally) – and the anti-establishment Five Star Movement, did not win the March election by pandering to Brussels. While the two parties insist they do not want to leave the EU or the euro zone, they vowed to set their own economic and financial course, and damn the fiscal gnomes in Brussels.

In came a proposed budget deficit equivalent to 2.4 per cent of gross domestic product. The EU howled because the deficit was three times the level that had been agreed upon by the previous government, and up sharply from the 1.8 per cent targeted this year. The EU’s argument is that a country with a debt-to-GDP ratio of 131 per cent, the second highest in the EU after Greece, cannot afford a fat deficit that will only slather more debt onto the country’s €2.3-trillion ($3.45-trillion) pile of liabilities. A financial crisis in the third-largest economy in the euro zone could wreck the entire EU. Imagine Greece times 10.

The populist government took the opposite view: Italy needs an expansionary budget to kick-start the economy after a decade of negative or scant growth. The government says it’s finished with austerity and is sticking to its guns. In recent days, Prime Minister Giuseppe Conte and his powerful deputy prime ministers – Matteo Salvini, head of the League, and Five Star leader Luigi Di Maio – have vowed not to back down. While they have suggested that some aspects of the budget may be tweaked and that the deficit should fall in 2020, they also say the overall spending plan for next year will remain intact.

The tough-guy posturing has worked well for the populists, especially for the bear-like Mr. Salvini, who has emerged as the public face of the government. He scored points among voters by stopping migrant boats from docking at Italian ports. He’s doing the same by beating up on Brussels. Since the election, the League has soared in popularity and has gained momentum in regional polls. If an election were held tomorrow, there is little doubt the League, which was a clapped-out northern Italian party with zero presence in the south until a couple of years ago, would come out on top.

The battle between the EU and Italy will not end in smiles. The EU does not actually have the power to force a national government to scrap a budget and draw up a new one. All it can do is impose sanctions on Italy in the form of financial penalties if the budget is not rewritten to its satisfaction. But sanctions are improbable and in reality impossible to enforce. The EU knows that hauling out the heavy artillery will only play into the Italian government’s hands. The EU can only hope that the Italians offer a tweak or two that would allow it to say that the budget has been modified.

The Italians will probably make minor changes to the budget. But implementing a budget whose spending plans are largely or entirely intact could still backfire on them. That’s because it is investors – not the EU – who will be the final judge of the budget, and so far they don’t like what they see.

Since the budget turmoil began a few weeks ago, yields on benchmark Italian 10-year bonds have soared (yields and prices move in opposite directions). On Tuesday, the yield was 3.6 per cent, by far the highest among the euro zone countries, bar Greece (Spanish yields were at 1.7 per cent). The spread, or gap, between Italian bonds and German bonds, considered the safest in the euro zone, was almost 3.2 percentage points. Before the election, the spread had been a mere two points.

Italian risk has climbed so much that last week Moody’s downgraded Italian debt, putting it one notch above “junk” status. Standard & Poor’s could do the same this week. If it does, Italian bond yields might rise and the spread might widen. An Italian debt crisis might not be far behind.

The EU cannot defeat the Italian government’s budget plans, but the markets can. No nation can be truly sovereign if it depends on international and domestic investors to fund its debt. Italy has a crushing debt load and investors will ultimately call the shots on the country’s spending plans whether the populists like it or not. ​

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