Tackling the free rider problem in the EMU does not have to be a zero sum game: Italy’s budget deficit case

Tackling the free rider problem in the EMU does not have to be a zero sum game: Italy’s budget deficit case

The Italian government has plans for tax and spending that are now seen as one of the biggest challenges to the way the Economic and Monetary Union (EMU) runs. The Italian spending package, which was rejected last month in a historical move by the European Commission, has now been revised downwards by the government, however fundamentally reflecting Rome’s refusal to accept any clues in backing-down. This opens a whole new chapter for political risk in Europe. The revised program still involves a new citizens’ income, more generous pensions through a reduction of the pension age and lower taxes. Estimates suggest these measures will cost 2.4% of Italy’s GDP in 2019 (dropping to 2.1% in 2020), clashing with the EMU’s fiscal rules.

On November 13, 2018, the IMF published Italy's Staff Concluding Statement of the 2018 Article IV Consultation, suggesting Italy should implement a fiscal consolidation plan “based on high-quality measures” - together with a package of structural reforms, and bank balance sheet strengthening - as there are currently too many downside risks to increasing public expenditure. This is also in the light of the IMF’s more conservative output gap projection for Italy, compared to the OECD, the European Commission and the Italian government. The further IMF endorsement of fiscal attentiveness comes as no good news for the Italian government. As highlighted by many recently, including Daveri (2018) on the Italian watchdog lavoce.info, the reform package proposed by the Italian government, even if in its revised form, is clearly not set up right, being a burst to the national economy, with no effective growth prospects. This is because of mere deficit-spending social policies proposed, the “bill of which is essentially being footed by enterprises, banks and insurance companies”.

Figure 1

This idea that financial markets act as an echoing chamber for budgetary rules is not new to the EMU debate. There is also a sense that part of the “bad economics” or “policy mistakes” (Sandbu, 2015) which led to the sovereign debt crisis in 2010 are partly imputable to the wrong rhetoric on austerity (as Simon Wren-Lewis, 2018, underlines in a recent blog post), missing a key point on the Eurozone crisis: countries issue debt in a currency they have no control on. Here, the ECB could not – for political reasons – in the first instance act as governments’ Lender of Last Resort (LoLR). This is what De Grauwe (2018) calls a ‘harder’ budget constraint on EMU member states.

From the point of view of deficit spending, and its political underpinning, one important dimension to consider is the international / credibility dimension. Italy has lower total indebtedness – private and public combined – than Britain, France and Spain. However, as far as the EU’s fiscal criteria are concerned, only public debt matters. In addition, other issues are affecting the country’s international stance, including the distribution of NPL across the banking sector (Codogno and Monti, 2018), “home bias” or the excessive reliance of public debt’s ownership by the private sector (62.1% of government debt as a percentage of total government debt is held by domestic financial institutions (incl. central bank))[1], as well as important competitive issues which have resulted in a dramatic loss of competitiveness over time.[2] Currently, Italy is also the euro area country with the highest expenditure on interests on past debt (as % of GDP), and was projected already last year to be the EMU country with the highest gross financing needs (as % of GDP), according to the European Parliament (2018).

Currently, the projected deficit increase, under the threat of a sanctioning being activate at the European level through the fiscal compact’s corrective arm (the so-called Excessive Deficit Procedure, EDP; see Cohen-Setton and Leandro, 2018), is increasing the premium investors demand on Italian government bonds, signalling de facto capital flight, as investors may be perceiving a greater redenomination risk. During the last few months, Reuters’ Ramnarayan and Carvalho (2018) have discussed how the data on spreads between the 10-year Italian government bonds against the German bund show Italy being progressively clustered alongside with Greece, rather than Spain and Portugal, which show little effect of contagion. As Figure 1 shows, from April 2018 onwards the spread of Italy has increased significantly on two occasions while those of Spain and Portugal remained close to previous values.[3]

How much “politics” is there in EMU fiscal rules?

There are consistent arguments to put forward proposals that limit the budget deficit of Italy, in the absence of measures addressing the structural concerns of the Italian economy which should be tackled through outright reforms (see IMF, 2018). One above all is that the current government may not worry about the true costs of skipping the chance for debt reduction, since the burden will fall on future taxpayers and governments, thus providing an incentive to offload these costs to future generations. This is something not new in the history of Italy’s debt creation – starting from 1982 the Italian debt literally shattered (see Marro, 2018) without the – then – future taxpayers could participate in the decision process, nor their interests be taken into account.

Said that, the problem with the Italian political impasse currently is that, as the result of financial market risk-pricing, the country’s political clout in EMU affairs has been reduced and any residual fiscal capacity eroded. This has to do with the very nature of the EMU, which, in the absence of federal guarantees, risks becoming a zero-sum game. The ECB’s constitution does not allow for the bailout of a member state. In the past the problem was not perceived as dependable (i.e. the EMU zero no bail out clause was simply “not credible”; see Fuest and Peichl, 2012) if a large country (such as Italy) were to run into problems. Today, in the absence of fiscal and political entities like in the U.S., the country is confronted with a hard budget constraint because things are politically different.

How does this play with the current situation?

In the past, no credible ways of enforcing sanctions on sovereign nations were adopted (e.g. Germany and France in 2004/05). In addition, the way the conundrum of the absence of a LoLR was solved, at the peak of increased market speculation in 2012, was through the ECB’s President announcement of the ECB’s readiness to do “whatever it takes”, which marked the introduction of the Outright Monetary Transactions (OMT). The crisis further triggered important reforms of European governance framework, including medium term a Banking Union for Europe yet to complete (exp. 2026; see Macchiarelli, 2016). The OMT however is challenging to adopt, as it represents monetary policy with conditionality, the implications of which are not clear a priori, hadn’t the mechanism previously been tested.[4]  

There should be no stigma in using fiscal policy for growth support (this relates to the issue of EU legitimacy, as De Grauwe, recently noted), however one should consider the cost of sustaining aggregate demand – consumption, in particular – through bursting public expenditure, against the increased uncertainty it creates because of political risk. This risks weighting negatively on (business) confidence resulting, on balance, into a negative fiscal expansion (Blanchard and Zettelmeyer, 2018)

There are currently five options for the Italian case (Table 1).

1. The first option is a situation reminiscent of what happened during the sovereign debt crisis, where, under the course of several political frictions and rebuttals, financial markets were essentially able to tip the scale towards budgetary consolidation and hence heavy fiscal restraints and competitiveness adjustments (through ULC devaluation) in a country like Greece. Something similar could happen if things escalate, the EDP is activated and investors’ confidence drops further, meaning the Italian budget showdown will play in favour of the European Commission’s policies; something many would read as an Italian Commissariamento.
2. The second, less likely as well as less desirable option, is that the Italian government will not back-down in the budget standoff, by introducing, for instance a parallel currency without leaving the euro.
3. Third, there would be complete flexibility on the Italian budget, as it was the case for Germany with the Hartz IV reforms and the violation of the Stability and Growth Pact in 2004 with the Romano Prodi’s presidency at the European Commission (see De Grauwe, 2018).
4. An intermediate solution to point (1) and (3) (even if possibly more skewed towards (1)) would be a situation where the European Stability Mechanism would be activated. In case of an ESM involvement, as Praet recently signalled, the country will have to take correctional (structural) measures anyway, thus overriding the national political economy. The advantage will be, though, that it would make it eligible for the OMT which would help the government step towards a sustainable path, by lowering sovereign borrowing costs down. In this case as well, however, the ESM policies may have to supersede the government’s commitments with the electorate.
5. The last option will involve the recognition that this political shutdown underlines something else, requiring a further opening at the E(M)U level.
    
   Table 1

The biggest weakness in the bloc is now politics and the current approach to the Italian crisis would not increase the E(M)U popularity. As many have underlined, democratic expectations cannot clearly be set at the same level as within nation states as the latter re-distribute 40-50 percent of the GDP while the EU budget is a mere 1 percent of GDP. The euro legitimacy of the EMU is nevertheless key and the “politics” beyond fiscal rules makes the principle of “no taxation without representation” more relevant than ever for the Italian political standoff (see De Grauwe, 2018). Support for the euro has been rising in the past couple of years, but this is fragile. At the beginning of last year, the vast majority of Italians expressed discontent about the EU’s handling of the refugee crisis and the economy. Italy has currently a Eurosceptic majority and it is more disenfranchised than other countries (about 60 percent saying they felt their country's voice did not count in the EU) according to Eurobarometer data. This suggests that, notwithstanding the fact that the Italian badly designed budgetary plan needs addressing, and coping with the logic that the bloc has now stricter fiscal rules (including the semi-automaticity of the EDP sanctions through a reversed majority voting), there is a need for euro area reforms and more mutual recognition. Practically, the instrument to achieve this would be have to certainly combine risk reduction at the E(M)U level (e.g., Capital Market Union) and, certainly, at the national level through lower sovereign debt (as a part of the 2-Pack, 6-Pack and Fiscal Compact) and cap exposure by banks (see IMF, 2018). It would require, at the same time, signalling at the EMU level more concessions on combining risk sharing (Sapir, 2018), through an excplicit fiscal agreement.[5] In other words, a policy that focuses on the stick and no carrot at the EMU level hasn’t worked in the past and will certainly not work in the future, particularly if the EMU is looking to create a consensus and a convergence of (political) interests from the bottom.

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[1] Also as the result of ECB policies eroding financial institutions’ profit margins, see Macchiarelli (2018).

[2] In Italy, wages are set at the sectorial level and extended nationally. This implies nominally rigid wages which do not respond well to firm-specific productivity, regional disparities, or skill mismatches, requiring labour demand adjustments through lower profits and number of people in employment and/or hours worked.

[3] This something Schwendner (2018), extending the methodology from the European Stability Mechanism, also underlines.

[4] In particular, in terms of the government prospects of accessing financial markets in the future.

[5] Sapir A.(2018), “Euro Area Governance Politics is Crucial”, Paper Presented at the Joint NBB/TSE/SBSEM/ECB Conference “Managing Financial Crisis: Where do we stand?”, Brussels, 5/6 November.