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.

Italy’s longstanding growth challenge is being amplified by Europe’s recent loss of economic momentum, regional fragmentation pressures, and the gradual reduction in liquidity injections by the European Central Bank. To counter these factors, Italy is resorting to fiscal policy to try to stimulate growth through both demand and supply channels. In other words, the government wants to run a larger budget deficit now in order to generate higher actual growth and higher potential growth.

Meanwhile, the pressure on Italian risk spreads has been accentuated by a shift in global markets. The past several years have been characterized by unusually low market volatility and an appetite for higher risk, owing to ample, repeated, and predictable liquidity injections from central banks. But markets are now moving toward greater risk aversion and higher volatility as monetary policies tighten and as growth – particularly in advanced economies outside the US – slows and becomes more divergent.

Looking ahead, much will depend on whether Italy’s big policy bet can be reconciled with the rules and guidance of the European Commission. But make no mistake: global factors will also play a role, not least by determining how much time Italy and the Commission will have to sort out their differences.

The writer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund.

Copyright: Project Syndicate.