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).
- 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.
- 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.
- 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).
- 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.
- 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.
[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.
