In recent weeks the eurozone crisis flared up again, this time on the occasion of a debate between the European Commission and the Italian government over the latter’s new budget proposal. The Commission rejected Italy’s budget on the grounds that the proposed 2.4% fiscal deficit is in violation of the Fiscal Compact whereby countries need to aim towards a structural (i.e. cyclically-adjusted and excluding one-off measures) budget deficit given by their so called medium-term objective (MTO) – which is zero percent for Italy, a country with a very high 132% debt-to-GDP ratio. According to the Commission, the current budget proposal entails a deterioration in Italy’s structural balance of 0.8 percentage points, while they were advocating an improvement of 0.6 pps (adding up to a deviation of 1.4 pps), and threatens sanctions if Italy does not comply.
Financial markets are jumpy, Italian government bond yields are rising, and “lo spread” is again a closely watched indicator. Several commentators (especially in Germany) are accusing the newly elected nationalist-populist-eurosceptic Italian government of not respecting the commonly agreed rules and of irresponsible foolish behaviour which will not only bankrupt their country but could threaten the stability of the euro as well. Italian public debt is already huge, so more spending is certainly not what the country should be doing, they say. But is this degree of hysteria around the slightly higher Italian fiscal deficit really warranted from a purely economic perspective? Not necessarily.
In this three-part essay I look at
whether fiscal stimulus is warranted in Italy (and why hysteria about the fiscal deficit is overblown)
the role of Germany and austerity bias in the eurozone [link]
Let’s take each in turn.
1. Is fiscal stimulus warranted in Italy?
Fiscal policy normally has a role in cyclical aggregate demand management through automatic stabilizers (like unemployment benefits or progressive taxes), but this role increases even more in liquidity traps (with monetary policy constrained at the zero-lower-bound) when some discretionary fiscal stimulus is also warranted. In other words, whenever aggregate demand (actual GDP) is weaker than the economy’s supply potential, we have a negative output gap which should be closed by macroeconomic policy stimulus. The idea behind the “structural budget deficit” is that it filters out these effects of business cycle fluctuations on the budget, so a higher headline deficit due to e.g. more unemployment benefits will not be reflected in the structural number. The fact that the Fiscal Compact’s MTO is defined in terms of the structural balance is supposed to provide flexibility for governments to pursue this kind of Keynesian countercyclical fiscal policy.
If the supply potential is estimated to be higher, the currently observed weak aggregate demand (as measured by the GDP) indicates more slack in the economy, justifying more fiscal stimulus (also, the structural budget balance is expressed as a percentage of potential GDP, meaning that higher potential output would lower the structural deficit number). So it all comes down to how negative the Italian output gap really is. According to the European Commission’s estimates, Italy has now a slightly positive (!) output gap (corresponding to a low and damaged potential GDP), which is the source of their large structural deficit estimate. In other words, the Commission thinks that Italy’s growth problems have to do more with structural problems in the supply side rather than weak aggregate demand. Given this, macroeconomic demand stimulus is unlikely to boost growth, but it would just lead to higher inflation, and Italy should rather focus on structural reforms to repair its supply side instead of more fiscal spending.
However, the problem is that the economy’s potential output, and hence the output gap, is not directly observable: it can only be estimated and is subject to substantial uncertainty, especially in real time. According to some analysts, the Commission’s estimates are suspicious at best (e.g. see INET’s Orsola Constantini, FT’s Martin Sandbu or Matthew C. Klein). The EC’s estimates of potential output seem to track actual GDP too closely, as if a large part of economic fluctuations is supply side related, which is quite unlikely given the huge negative demand shock of the financial crisis. Italy’s GDP is still 5 percent below the pre-crisis peak (while the euro zone as a whole is 7% above), meaning that the average Italian is barely better off than 20 years ago. The unemployment rate is also more than 10%, still above the 2008 rate across the country, with youth unemployment around a staggering 30%. With such poor numbers it is hard to argue that Italy has fully recovered to its potential (even taking into consideration weaker pre-crisis trend-growth) – but at the very least, the case for more demand stimulus should not be dismissed right away.
Of course, the proper reference point is not necessarily the “pre-crisis peak” where the economy was probably already overheated with a positive output gap – but the amount of shortfall from the pre-crisis trend is just still too large. In addition, it might very well be that the prolonged period of weak demand has damaged the potential of the Italian economy, closing the output gap “from above” (and bending the dashed trendline downwards). This is the so called hysteresis effect, whereby idle capital stock gets depleted, long-term unemployed workers lose skills and drop out of the labor force, and technology-enhancing innovation is postponed. It is very likely that Italy suffers from the hysteresis-induced damage to its supply potential. But then the argument should cut both ways: if weak demand can damage potential output, then strong demand (or even overheating the economy) can also help repair it, so hysteresis is hardly a case against stimulus! Indeed, in contrast to assumptions in the Commission’s framework, the supply side of the economy is unlikely to be completely independent of aggregate demand: more investment into capital, infrastructure, technology and skills, while boosting demand, also contributes to higher potential GDP.
One can argue that even though Italy might need some fiscal boost, it has simply no fiscal space anymore to do so, given its already huge public debt burden: even more spending would put debt-sustainability in question, so it is time for a more restrained budget. The problem with this argument is that containing the debt-to-GDP ratio depends a lot on how GDP grows and the latter is not invariant to the fiscal stance. Harsher austerity can be self-defeating if GDP growth is harmed more than debt growth is slowed. (Just think of Keynes’s paradox of thrift argument: the economy is a whole is not like a single household. Trying to spend less and save more can actually lead to less saving as incomes fall. Somebody’s spending is another person’s income and the two must be equal on the macro level – if we abstract from exports). If a fiscal stimulus manages to bring the economy back to its growth-trend, or even better, improve the long-run growth potential of the country, then it actually improves debt-sustainability. That is why low Italian growth rates are not an argument for austerity on the grounds that a low-growth country can only support smaller debt – they are rather an argument for stimulus on the grounds that debt cannot be supported with low growth. Case in point is Greece, which after years of imposed harsh austerity has lost a quarter of its GDP, and its debt-to-GDP is now higher than before, even after a substantial debt write-off.
Interest rates also matter for debt-sustainability. Issuing debt in a near zero interest rate environment should finance itself even if it contributes to positive nominal GDP growth only slightly. Of course, Italy pays on its bonds a substantial premium over the ECB interest rate, but a large part of that spread could be eliminated with a better design of the euro (more about this later, in the third part of this essay).
Several commentators also raise the issue of intergenerational fairness, saying that spending more today by indebting future generations is immoral. Even if the public debt is never to be repaid in full (as it is just rolled over), the interest-cost of servicing such a large debt-pile can be a substantial burden in the future. While this may be true, this cost must be traded-off against the huge costs of continued austerity today. It should also be noted, that a large fraction of Italian debt is held domestically, so interest payments are not that big of a burden for the economy as a whole (even if they lead to redistribution). In addition, as pointed out above, fiscal stimulus today can actually improve debt-sustainability for future generations by putting a quicker end to a weak-growth period. Moreover, it is rather continued austerity which is intergenerationally unfair: by maintaining the 30% youth unemployment rate, and contributing to the hysteresis effect, a generation of young Italians will have a hard time transitioning from school to working-life, missing out on acquiring skills, and having lasting damage on their career and earning-prospects. The harmful effects of austerity can resonate for decades to come.
According to some, the expected growth effects of the Italian government’s larger budget deficits are overly optimistic and claim that they will not achieve the desired boost to GDP. As recent research by Summers & DeLong, and Christiano, Eichenbaum & Evans, or Eggertsson or Woodford has shown, fiscal multipliers are much larger in a liquidity trap (i.e. when the zero lower bound on interest rates binds) than normally, meaning that an extra euro of budget deficit can generate a more than a euro GDP and income in the economy. This is because the usual crowding out effect of fiscal expansion on investment and consumption through raising interest rates is absent at the ZLB. (Fiscal multipliers can also be larger than previously assumed, due to the presence of liquidity-constrained households who are not sensitive to the interest rate, or the presence of countercyclical risk whereby higher incomes due to a demand stimulus mitigate consumers’ precautionary saving motives, further boosting demand. See Bilbiie or Auclert et al or Ravn & Sterk). Based on these academic results, the Italian government can expect quite a big bang for its buck, especially now that the ECB still keeps interest rates at zero. What this means is that achieving a given increase in GDP-growth requires a relatively small increase in the fiscal deficit. Despite this, the estimated fiscal multiplier effects of 0.3 in the government’s budget draft proposal seem quite conservative and are definitely not “overly optimistic”.
Still, there are many who say that the proposed Italian budget will not manage to achieve the supposed stimulative effect, or improvement in the supply potential. Bruegel’s Alessio Terzi writes that due to structural issues, like corruption or messy bureaucracy, the efficiency of Italian public investment in raising growth potential is very low, so reforms must come before stimulus. Even if this is so, the beneficial effect on demand and unemployment of even purely wasteful government spending should not be ignored through the reverse-hysteresis channel or by closing the negative output gap (which Terzi accepts to be positive, in line with the Commission’s questionable methodology). Of course, it should be acknowledged that Italy does suffer from serious supply side problems, as reflected in its terrible productivity growth record, which is why structural reforms are undoubtedly necessary. On the long run, demand boosting policies are surely not the solution to anaemic growth, a very rigid labor market, a poor education system and unfriendly business environment (as summarized by the FT). Implementing the necessary reforms are much easier though, when supported by demand stimulus, especially when there is still some slack in the economy, even compared to its admittedly weak potential output.
The problem with the Italian budget proposal seems to be its composition rather than its size. As pointed out by Martin Sandbu, or the FT’s Editorial Board, the Lega-M5S government’s budget includes flat tax for companies, increase in welfare spending through a minimum income, and a cut in the retirement age (which shrinks the labor force), while barely spending anything on infrastructure — it is hardly a “Keynesian revolution”, while not tackling the structural problems, either.
That said, the current hysteria around the “profligate” Italian budget seems to be not about its composition but about its headline deficit number – which at 2.4%, well within the 3% Maastricht limit and just slightly higher than previously planned, is hardly the embodiment of fiscal irresponsibility it is painted to be, especially for a country with a most probably negative output gap and years of weak growth behind it. Arguing against it on these grounds is therefore not warranted, and just fuels the austerity bias of the eurozone which contributed to its lacklustre post-crisis recovery.
Why this situation could still lead to serious problems and why the crowding out effects through higher government bond yields could still materialize even at the ZLB, is less the fault of Italy’s fiscal policy than of the flawed monetary design of the euro – to which we turn in the third part of this essay. But first, an account of what lead to here: austerity bias in the eurozone.