I received several comments to my latest post on the budget debate between Italy and the European Commission. Here I just want to emphasize three points, which I have already mentioned in the previous piece but perhaps might not have stressed enough.

1) First, criticizing the Commission’s approach or EU fiscal rules does not mean endorsing or supporting this particular budget of the Italian government (or that government itself, which I do not). It is true that the budget has a bad composition, especially its proposed pension reform shrinking the labor force, and the lack of badly needed infrastructure spending, which is why it is indeed much less likely to be stimulative. I am also not questioning that Italy suffers from serious and chronic supply side problems, as embodied in its stagnant productivity, which warrant structural reforms. But as Ashoka Mody rightly argues, this is beside the point. What I am saying is that Italy needs a well-designed fiscal stimulus because the country still suffers from weak demand relative to its supply potential – however damaged the latter may be. And when the Commission argues against a higher fiscal deficit per se (instead of its composition), it is like getting the bad guys for the wrong reasons – as well as strengthening the austerity bias of the eurozone.

2) Second, fiscal multipliers of deficit spending are indeed lower when there is crowding out through higher interest rates – or in Italy’s case, higher spread. Olivier Blanchard and his colleagues estimate that the stimulative effect is likely to be fully (if not more than fully) offset by the contractionary effects of the rise in interest rates faced by Italian economic actors. This is basically the "confidence fairy" (expansionary austerity calming creditors worrying about debt-sustainability) operating in reverse, leading to a contractionary fiscal expansion. This is exceptional (i.e. unique to the current Italian case), even according to the authors who argue that a fiscal expansion should normally be expansionary - but the reaction of bond markets now seems to be rather spooked. Moreover, a sufficient rise in the direct interest cost of servicing the already huge public debt pile might overshadow any gain which the government gets from slightly widening the budget deficit and spending more. But this is exactly why I say (as Corsetti, Dedola and coauthors), that the ECB should rule out default risk in this situation in order to contain the spread and accommodate fiscal expansion at the zero lower bound. In a country with its own currency fiscal multipliers are large during a liquidity trap because the central bank does not offset deficit spending by raising interest rates – nor there is a fear of default driven by bond market sentiment which would raise the spread, since owning a printing press essentially makes debt non-defaultable. The eurozone should be able to coordinate on this kind of monetary-fiscal policy mix.

3) Third, and related to the previous point, calling for ECB guarantee of member state government debt under certain conditions is not equivalent to a call for access to unconditional monetary financing. In a multi-country currency union the threat of default is needed to discipline moral hazard concerns, so access to the printing press should be conditional on fulfilling some fiscal rules/criteria, and limited to situations when it is actually needed (like in a liquidity trap). But that dos not mean it must be ruled out completely. My point is that it should not be market sentiment but rather politicians/central bankers who decide when a member state should be able to implement fiscal stimulus without increasing its default risk. Currently there is no such criteria at all: monetary financing is completely forbidden by the Treaty which subjects member states to market sentiment and real default risk, even when fiscal stimulus would be warranted. Or more precisely, the ECB’s Outright Monetary Transactions program is available to intervene in the government bond market, but its conditionality of having to submit to a harsh austerity-biased intergovernmental bailout program is defeating the original purpose of demand stimulus. The conditions for accessing this program should be more flexible, allowing for more countercyclical fiscal policy. As Corsetti and coauthors say, in a liquidity trap switching to active fiscal stimulus, enabled by a passive monetary policy which keeps interest rates low and makes debt non-defaultable, is desirable. Otherwise default-fearing debt markets will halt and/or neutralize the needed fiscal stimulus through higher risk premium. This might require some monetary financing or debt monetization through higher inflation, and the associated risk-sharing across countries, but this is unavoidable for a well-functioning monetary union (that said, even the promise itself might be enough).

Concerted monetary-fiscal actions are needed for Italy to escape from weak demand. Currently it seems to be getting neither. Nor is its situation eased by more robust external demand coming from its main trading partner, which keeps running large current account surpluses. If the Commission and the Italian government does not strike a compromise, then the ECB’s ability to intervene will remain limited, and a vicious spiral in the bond markets might still lead to the “mother of all financial crises”. Avoiding this is possible, but it depends on policymakers.