There is a common moralising narrative according to which “profligate” euro periphery countries were living beyond their means, were overspending in the form of consecutive fiscal deficits, and were irresponsibly running up debt, so now that the day of reckoning has come, they must necessarily tighten their belts to atone for their past excesses. Apart from the more general point, that this argument is subject to the fallacy of composition to the extent that it treats the macroeconomy as if it was a single household (see e.g. Keynes’s paradox of thrift argument, and my argument in the previous part about self-defeating austerity), and that it ignores fiscal policy’s role in countercyclical demand stabilization, the more particular problem with it is that, in Italy’s case at least, it does not seem to be true – at all.
Looking at the budget deficit of Italy since it joined the euro, we can see that it is not far out of line relative to the other main European economies. Once we take out the cost of servicing debt, we get the actual difference between what the government spent in the economy and what it raised as tax revenue (the primary budget deficit), i.e. what Italian people were getting in net from the state. This measure is and has been in surplus for almost 20 decades now, and at par with prudence champion Germany. If we further adjust for the effect of the business cycle, allowing for fluctuations in the deficit due to aggregate demand stabilization, we get the most appropriate measure of “fiscal stance”, i.e. how stimulative/austere is fiscal policy relative to the cyclical position of the economy. This indicator signals that Italy’s fiscal policy has been among, if not the, strictest (!) in Europe over this period, with continued surpluses, even higher than disciplined Germany. In addition, although large in absolute terms, the Italian public debt-to-GDP ratio was actually decreasing until the crisis; and even with the increase since then, Italian debt growth since the euro began is still among the lowest in Europe (see charts).
All this is hard to square with the image of a spendthrift country incapable of fiscal restraint, which Italy is painted to be. It rather paints a picture where Italian people on average have been living under more austere conditions than their European neighbours. Hefty primary budget surpluses are all the more striking for an economy with weak private demand and a most likely negative output gap. Given all this, it does not seem to be a big ask from Italian voters to let fiscal policy ease a little (not even by much!), especially after the biggest crisis in 80 years from which the economy has still not recovered fully.
Of course, whatever the effect on citizens and the underlying true fiscal stance is, it does not change the fact that interest on debt must be paid, which is why the headline budget balance is in deficit. Therefore even if one accepts that Italians are not to be blamed as irresponsible overspenders, they can still say that a country which inherited such a huge pile of public debt from their grandparents, simply, and sadly, has no other choice: financial markets and outsiders will not care about who is to blame when deciding whether to finance more Italian debt – they will only care about debt-sustainability which limits the fiscal room for an already grossly indebted Italy (more about how to address this in the third part of this essay). However, notwithstanding the previously discussed potential for a demand stimulus to actually improve debt-sustainability, what also does not seem to be sustainable is to sentence Italians to perpetual primary budget surpluses, fiscal austerity and low living standards, depriving them of even minimal countercyclical fiscal flexibility in the name of paying down their ancestors’ debt. This will inevitably lead (or rather, has already lead) to democratic backlash, potentially destabilizing and threatening the whole European integration project. Already tiny Greece posed a serious challenge, but a country the size of Italy will not be as easily bullied.
But it is not just strict EMU fiscal rules and tight Italian fiscal policy which constrained Italy’s post-crisis recovery. A major contributor were tight fiscal stance and weak demand elsewhere in the euro area on the one hand, and the asymmetric current account rebalancing within the eurozone on the other, which forced the burden of adjustment mainly on peripheric deficit countries. I have explained this in detail in my earlier post where I lay out the case that irresponsibility lies rather with CA-surplus countries like Germany who are not willing to spend, thereby depriving the rest of the eurozone from aggregate demand. I recommend going through that post, but here are the main points in summary. First, building up large CA-surpluses (meaning excess saving over investment) during a liquidity trap in a currency union, where neither interest rates nor exchange rates can adjust easily any more, imposes further deflationary and recessionary effects on trading partners, as it captures already weak aggregate demand (for an illustrative model see Blanchard). Second (as Keynes has already pointed out at Bretton Woods), when rebalancing needs to occur, putting the adjustment burden asymmetrically on CA-deficit countries – i.e. requiring them to save more and/or go through painful internal devaluation causing Fisher-type debt deflation and increasing real debt burdens, while surplus countries neither need to spend more nor tolerate higher inflation – further weakens their domestic demand and raises unemployment.
Given these considerations, in the eurozone then it is not hard to see why persistent and record high German current account surpluses (currently above 8% of GDP, eclipsing that of China!) pose a problem. Just to indicate the consensus among non-German macroeconomists on this matter, I would guide the interested reader to The Economist (1, 2, 3, 4, 5), former fed-chair Ben Bernanke, Barry Eichengreen of Berkely, FT’s Martin Wolf (1, 2, 3, 4), Gavyn Davies (1, 2) or Simon Wren-Lewis of Oxford (1, 2, 3, 4, 5, 6). Germany could afford to restrain its domestic demand and build up savings without suffering higher unemployment because its export sector could rely on external demand and the willingness of its trading partners to spend. It is hard to follow the same route for euro periphery countries if their main trading partner, Germany, is not willing to spend: again, one’s income (from which they can save) is the other’s spending. This became even harder after the crisis as the asymmetric burden of CA-rebalancing meant that deficit countries could only increase their savings by constraining their domestic demand, since they could still not rely on more external demand through more German spending. As the eurozone fell into the liquidity trap, where interest rate cuts could not offset this rise in periphery saving desire any more, it meant that incomes had to adjust, leading to higher unemployment and negative output gaps across Southern Europe – continued German CA-surpluses essentially imposed a deeper recession on the eurozone.
The pain of this adjustment and rebalancing could have been substantially eased if only Germany started spending more, which it could easily afford. Barring a short period of fiscal stimulus after the crisis, the German government is sticking to the “schwarze null” policy of balanced budgets, even though the country badly needs more infrastructure spending. The saving rate of the private sector was also pushed up by reforms which depressed the real wages of (high-spending) German workers, and redistributed income towards (less-spending) wealthy firm owners. The median German household is therefore not even a beneficiary of this policy: they have low real wages and are relatively asset-poor in European comparison despite large German savings on the macro level: “Most Germans’ living standards have stagnated, wealth is highly skewed and national saving has been spectacularly badly invested.” (This also shows that despite the appearances and the political narrative, it is not countries but rather economic sectors facing off each other in the euro crisis).
What’s more, (although it does not affect Italy that much), the excess savings Germany accumulated in the run-up to the crisis were an active contributor to fuelling financial instability in the euro periphery as they were irresponsibly invested into risky assets like Spanish and Irish real estate (or US subprime mortgages) and Greek government bonds. The destabilizing capital outflows accompanying the excess saving-induced German CA-surplus fuelled financial bubbles in countries on the receiving end of these flows. Before protesting that nobody can force southerners to borrow, note that the fall in interest rates indicates that it was more like a “push” from larger and eager German loan supply rather than a “pull” from larger Southern borrowing demand trying to convince reluctant German lenders. In other words, it was not (just) irresponsible southerners letting their competitiveness deteriorate and going to Germany for loans to finance their ensuing current account deficits, but that an independent increase in German savings were also responsible for fuelling easy borrowing conditions and credit bubbles in the South (see Erik Jones). As Michael Pettis and Matthew C. Klein argue, “if enough money is sloshing around willing to invest in any stupid idea, you shouldn’t be too surprised that a lot of stupid ideas get funded […] it’s logically impossible for excess borrowing to occur unless there is someone sufficiently reckless (or stupid) to provide the financing.” Who is the irresponsible here? (see footnotes * and **)
In the context of Italy, this shows us the important role Germany played in the current situation. It is hard to grow out of your debt and/or save more when your main trading partner is not spending so you don’t have enough income. It is even harder when the asymmetric CA-adjustment burden on euro deficit countries requires to constrain domestic demand and undergo internal devaluation, which then leads to recession and unemployment in a liquidity trap, amplifying the fiscal problems as the tax base is eroded. If those who can afford stimulus, do not undertake it, then more indebted countries like Italy will face more urge to run high fiscal deficits. Looking at Southern indebtedness in isolation of German excess savings and capital flows therefore does not make much sense. What makes equally little sense is judging “irresponsible” Italians who can only thank themselves for being in a bad situation of their own making, while morally superior “prudent” Germany washes its hands. If anything, the reverse has more truth to it.
The disappointing recovery of the euro area compared to the United States is in large part due to the insufficiently accommodative macroeconomic policy stance, including not just monetary policy (which is constrained by the ZLB) but also fiscal policy in the currency union as a whole. This is not only because of Germany’s unwillingness to spend per se, but also because of the corresponding asymmetric CA-rebalancing pressure on Southern deficit countries to restrain their domestic demand. Add to this the very strict fiscal rules of the EMU and the harsh austerity imposed on bail-out program countries, and no wonder that the eurozone suffers from deficient aggregate demand. The euro has an austerity bias, under which all adjustments are harder, unemployment and real debt burdens increase, creating instability and threatening the future of the single currency.
Germany has a responsibility in boosting eurozone demand. This would not only help Italy, but would also benefit German people. If those who can afford stimulus, undertake it, then more indebted countries like Italy will face less urge to run high fiscal deficits. While this assumes a minimum degree of solidarity and a feeling of shared destiny, if the euro is to work, Germany cannot shun this responsibility. Without more German spending and more robust eurozone demand it is no wonder that Italy tries to stimulate its weak economy and goes against the strict budgetary rules imposed by the Fiscal Compact. And recall, the irresponsible in a liquidity trap are not those who borrow, but those who do not spend (“virtue becomes vice, and prudence is folly”). So where the European Commission should rather be strict instead, is enforcing the Macro Imbalance Procedure which tries to make CA-rebalancing more symmetric in the spirit of Keynes by forbidding a member state to run a current account surplus in excess of 6% of GDP – the strongest eurozone member seems to be getting away with it.
However, even if EMU fiscal rules were relaxed, there would still be a further obstacle in front of fiscal stimulus for countries like Italy. Financial markets can potentially drive a euro country into default and banking collapse, which is not the case for other countries with their own central bank. The source of this issue is the flawed monetary design of the euro, to which we turn in the third and final part of this essay.
* This is not to say that Germany literally “dumped their savings on the euro periphery” as one would think in a loanable funds framework. Lending can take place even without collecting pre-existing savings, so capital flows from Germany to the periphery did not actually require German savings. They only required more willingness from German banks to lend. Savings were a consequence rather than a prerequisite of lending, and they materialized once the periphery spent those loans on German imports, restoring the accounting necessity whereby capital outflows must equal current account surpluses. It still remains the case though that Germany did not spend enough, maintaining these CA-surpluses and contributing to weak euro area aggregate demand.
** After the bubbles went bust, German lenders woke up, and stopped providing capital inflows. But instead of realizing losses on their risky investments, German lenders were essentially bailed out by their own government: this bailout however, was not direct but rather channelled through Spanish and Irish governments who in turn needed to bail out their own banks who intermediated German lending. Therefore, these bailouts did not really flow to periphery taxpayers, but rather compensated the losses of mainly German banks – nonetheless they were used to justify harsh austerity imposed on the periphery so that German taxpayers can recover from Southerners the cost of bailing out their own banks after their foolish investments.