Italy's budget issues: A problem of the EU's own making

Italy’s populist government has upset the European Commission with the release of its budget plans for the next three years, and the IMF has now got in on the act by warning that they risk upsetting markets. The whole furore is based on the fact that the current budget plans are higher than those outlined by the previous government. But by continuing to criticise the Italian government’s plans in public, the EC risks the very thing it is concerned about by driving bond yields higher, thereby raising debt servicing costs and exacerbating the debt problem. Whilst the EC’s criticisms of the Italian budget targets may have some validity, the fact is that EMU fiscal procedures are not fit for purpose – and perhaps never were.

To put it into perspective, the previous government targeted a deficit ratio of 1.6% of GDP which the EC deemed acceptable in order to help keep Italy’s high debt-to-GDP ratio in check. But the new government, a coalition between M5S and the League, pushed for a much higher deficit in order to fund some of its more populist schemes. Finance Minister Giovanni Tria, who is not a member of either party, initially tried to hold to the previous government’s plans but appears to have lost the domestic political battle. In late September, the budget plan envisaged a deficit-to-GDP ratio of 2.4% of GDP for the next three years but following concerns that this was too high, and despite claims by the Deputy Prime Minister that “we will not backtrack by a millimetre”, the government is now targeting deficit ratios of 2.4%, 2.2% and 2% in 2019, 2020 and 2021 respectively. 

Strictly speaking this is not an excessive deficit, which is broadly defined as 3% of GDP, and is the benchmark against which the Italian government judges its plans. But the EC’s fiscal rules are a lot more complex than they were prior to the financial crisis and it is the devil in the detail that has resulted in Rome and Brussels having very different opinions regarding the budget plans. In 2011, the EC introduced a series of reforms known as the “six pack”, one of which is designed to limit the growth rate of government spending to no more than the medium-term potential GDP growth rate. In addition, governments are now subject to Medium-Term Budgetary Objectives (MTOs), which in Italy’s case requires it to reduce the structural budget deficit to zero.

Of course the reason that the EC is so concerned about the Italian fiscal position is that it has very high debt levels (131.8% of GDP in 2017 versus a Maastricht Treaty reference value of 60%). But Italy has never even come close to meeting this threshold and was allowed into the single currency area despite a debt ratio that was way out of line with the entry requirements. Indeed, in November 2003 I wrote the following:

It is now far too late to impose on Italy the kind of fiscal austerity required to get the debt ratio down. The damage was done twenty years ago.

Italy’s problem now is that the EC’s concerns have spooked the markets and forced 10-year bond yields to their highest since early 2014 which will further raise budgetary pressures. Technically, the EC’s fiscal rules allow it to levy fines on Italy for failing to comply with its MTOs, which would be to add insult to injury. But this would be inadvisable. For one thing, Italy’s proposed 2.4% deficit ratio next year is below that of France (2.8%). Moreover, Italy is a net contributor to the EU budget to the tune of around 0.2% of GDP. And it is also the world’s third largest bond market. 

Unlike Greece, Italy will not be so easy to push around. The EC can huff and puff as much as it wishes but there are limits as to how much leverage it can exert if the Italian government is not prepared to cooperate. Perhaps more importantly, the very fact the EC is still talking about austerity after a decade of hard economic slog suggests there is a lot wrong with the rules. In any case, a couple of tenths on the deficit ratio does not mean much when the debt ratio is above 130%. By making an issue of it the EC risks exacerbating the problem, prompting a market reassessment of the whole euro zone bond sector, especially in view of the imminent end to ECB purchases. And as a final thought, two-thirds of Italy’s €2.3 trillion of outstanding debt is held by domestic residents (the ECB holds around 15%). Somehow, I can’t see the prospect of higher returns on these holdings being a great problem for yield-starved domestic investors.

EU may see it differently

Although the British government was given a bloody nose following last week’s Salzburg summit, events of the past few weeks act as a reminder that Brexit is one of the few issues on which the EU27 is able to present a united front, since almost all the leaders of the larger nations are facing mounting domestic difficulties. 

Nowhere is this more evident than in Germany where Angela Merkel is facing what looks to be a significant fracturing of the political consensus. In summer 2017, the CDU/CSU coalition was running at 39% in the opinion polls with the SPD polling 25% and the AfD 8%. Latest polls put the CDU/CSU at 28%, the SPD at 17% and the AfD at 16%. In the 20 years that the Emnid weekly poll has been running, the share of the CDU/CSU and SPD, which together represent the main German political factions, has never previously fallen below 50%. That the AfD and SPD are running neck-and-neck in the polls is an indication of how things have changed. The fact that the AfD has maintained its polling status even after the riots in Chemnitz is another illustration of that fact.

The ousting this week of a long-term Merkel ally as head of the conservative bloc's parliamentary group is an indication that her domestic opponents have been emboldened by apparent signs of political weakness. With Merkel already one year through her four-year term, and unlikely to stand as Chancellor at the next election, the beginning of the end of her time on the stage is apparently unfolding before us. 

Not that Emmanuel Macron has much to be satisfied with. According to latest polling data, only 28% of French voters are satisfied with his performance – down from 35% in July and compared with 60% in summer 2017. This puts him on a par with Francois Hollande’s polling ratings after a similar period in office, and way behind Nicolas Sarkozy. Macron’s problems are: (a) he does not enjoy as much support as his landslide election win suggested – many voters simply chose him because he was not the right wing Marine Le Pen; (b) he has been unable to deliver on his promise of a domestic political revolution, and (c) promises to cut taxes remain so far unfulfilled (see this BBC article for a closer look at Macron’s woes).

As I have noted previously (here), Italian politics has been in flux since the spring election as the League and Five Star parties continue to share an uneasy alliance. Current negotiations regarding the 2019 budget have been dragging on for weeks, with the technocratic finance minister Giovanni Tria under pressure to increase the budget deficit to accommodate the expensive election promises of the populist coalition government. There are concerns that a deficit in excess of 3% of GDP would be a problem for the European Commission, provoking a row over fiscal policy that would result in another general election next year. Whether or not this materialises is not the point: It is yet another distraction that Italian voters – and indeed the EU as a whole – can do without.

Factor in the ongoing problems between Brussels and the governments in Budapest and Warsaw, and the news that the Sweden’s  centre-left prime minister has been forced out by the centre-right bloc after an inconclusive election earlier this month, and the scale of the political problems facing EU leaders becomes evident.

Thus, when the British newspapers obsess about Brexit as if it were the only game in town, you can be sure that they have it all wrong. The trials and tribulations faced by Angela Merkel over recent months highlight the extent to which the old order is crumbling. When even the German Chancellor faces mounting domestic problems as a result of the EU migration crisis, it is pretty evident that something is wrong. The likes of Italy and Spain feel that they have been left alone to cope with the waves of migrants arriving on the EU’s doorstep whilst countries such as Austria, which are located on the main land route towards Germany, are concerned that migrants should exit their territory as quickly as possible.

Indeed, immigration is the fault line running through European politics. It was one of the key issues in the Brexit campaign – this was, after all the topic which most exercised UKIP under Nigel Farage – and played an important role in Dutch, French and Italian elections over the past 18 months. There is clearly no easy fix. Aside from any irrational prejudices that people may have, the economic issue is what effect will large migration numbers have on public finances, wages and per capita incomes. The UK evidence does not suggest that there has been any significant adverse impact on the economy. Indeed, much of the empirical work conducted over the last decade suggests that immigration has had no significant negative impact on the job prospects of UK natives. The evidence of its impact on productivity is less clear cut but due to the fact that the skill levels of those entering the UK are generally high – notably those coming from the EU – the empirical studies conclude that a 1 percentage point in the migrant share of the working age population raises productivity by anything between 0.4% and 2%.

But this cuts no ice with electorates which believes this all to be fake news. The fact that populists continue to squeeze the political centre is a concern for those politicians looking for traditional European solutions, involving compromise and rationality, to these 21^st century problems. Too many European politicians are fighting their own battles against populists to care too much about what the UK wants. If British politicians want to engage constructively with the EU27, it might help to recognise that the UK is not unique in any way – apart, that is, from being stupid enough to open a Pandora’s Box, in the form of a referendum, that will not easily be closed.

Italy redux

A few days ago, I noted that the formation of a populist government in Italy exposed many of the fault lines in the single currency area. I stand by that – except in one crucial respect: The government deal we thought had been ratified came undone after the president vetoed the selection of a Eurosceptic finance minister. So now it is a domestic political crisis as well as a problem for the single currency area. Should we worry?

In my view, it is highly unlikely that Italy would ever leave the euro zone. It may allow policymakers to take back control of monetary policy but as the Brexiteers discovered in the UK, “taking back control” is an illusory concept. The first thing the Italians would have to worry about in the event of reintroducing their own currency is how far would it fall, which provides a partial answer to the second question: by how much will real incomes be squeezed? Moreover, although the bulk of Italian debt is held by domestic investors, foreign investors would dump whatever they have and the stock market would also take a beating. And the already-fragile banking system would come under further strain. For the foreseeable future, Italy will remain in the single currency area. The alternative is too awful to contemplate.

But plans by French President Macron to try and get the euro zone back on track appear to be running into the sand. Macron proposes more inclusive solutions including establishing a European finance minister; a fund to support investment and turning the European Stability Mechanism – established in 2012 as a system to provide financial assistance for member states in difficulty – into a European IMF. In order for him to make progress with these plans requires German political support but following last year’s general election which weakened Angela Merkel’s position, she seems less inclined to support Macron’s efforts.

A letter from 154 German academics, published in the Frankfurter Allgemeine Zeitung last week demonstrated the depth of German opposition. They warned that the euro zone should not be turned into a liability union and listed five main arguments opposing Macron’s plans: (i) The use of the ESM as a backstop for the bank recovery programme will reduce the incentives to clean up banks' balance sheets; (ii) If the ESM is transformed into a "European Monetary Fund" (EMF), it will be under the influence of countries that are not members of the euro zone which will reduce the controlling influence of the Bundestag; (iii) A common bank deposit guarantee scheme will socialise the cost of previous mistakes made by banks and governments; (iv) The planned European Investment Fund for macroeconomic stabilisation would lead to further transfers and loans to euro zone countries that have failed to take necessary reform measures in the past; (v) establishing a European Minister of Finance with power over fiscal policy would further politicise the role of the ECB.

They conclude that “the liability principle is a cornerstone of the social market economy. The liability union undermines growth and threatens prosperity throughout Europe … It is important to promote structural reforms instead of creating new lines of credit and incentives for economic misconduct .... The euro zone needs an orderly insolvency procedure for states and an orderly withdrawal procedure.” We should not dismiss these views out of hand – after all, AfD started as a project backed by some members of the academic community. It is somewhat ironic that the academics endorse the proposal of the prospective Italian government that an orderly withdrawal procedure be set in place. But the letter also laid bare that the signatories are as much concerned with looking after the German national interest as with laying the foundation stone for a stronger euro zone – note in particular point (ii).

And this is a problem that lies at the heart of the euro zone – indeed, the whole of the EU. It is what drove Brexit and prompted the Italian electorate to vote for a populist government. EU citizens simply do not see why they should make further sacrifices for a project that appears very remote to them. Admittedly, they can touch euro notes and coins, so in that sense monetary union is tangible. But the political sacrifices required to make it work are seen as an unnecessary step.

Perhaps – as I noted in a post last summer – the single currency was simply a step too far for the EU. There again, European politicians have never made a sufficiently compelling case for the EU. It has been taken for granted for too long. If Brexit was a wake-up call for politicians to sell the European vision, they are taking a long time to learn the right lessons. And so far they are failing.

Italy exposes the fault lines (again)

We knew that the Italian election, held almost three months ago, had the potential to cause problems in the euro zone but having survived the French and German elections last year, most investors thought we would be able to muddle through in Italy. It seems we were wrong. Although the Five Star (M5S) populist movement won the most votes, it was widely assumed they would not be able to get anyone else to work with them to form a government. In the end they managed to stitch up a deal with the far-right League, which had previously existed as the Northern League and campaigned for separation of northern Italy from the south, to form a coalition that most investors believed to be the worst possible outcome.

Italy now has a very inexperienced government which has discussed implementing a tax-and-spend policy which has been estimated in some quarters to cost up to 3.5% of annual GDP. Not surprisingly, this has sent alarm bells ringing in Brussels and Berlin as the Italian government prepares to drive a coach and horses through the fiscal rules that underpin the single currency. There was even a suggestion a couple of weeks ago that Italy would ask the ECB to wipe out €250bn of debt as well as set up procedures allowing EU member states to exit the euro, which is of a piece with the Eurosceptic views of M5S . Having experienced a near death experience in 2012 with a rerun in 2015, it is hardly surprising that serious questions are being raised once again about the stability of the euro.

In truth, Italy has always been the fault line running through the single currency project. Not only were its deficits flattered by financial accounting manoeuvres to get it below the 3% of GDP threshold in order to qualify for EMU, but its high debt levels were completely ignored. Recall that debt was supposed to be below 60% of GDP, or falling at a sufficiently rapid pace, in order to meet the qualifying standard. Neither was met (see chart). However, this was not a problem for the first decade of EMU – but then the crash of 2008 happened. To think that the problems in Greece almost brought the single currency to its knees. Given the vast size of the Italian debt market, problems in Italy could shake the project to its core.

However, much of the admonishment heaped on Italy, particularly from Germany, misses a vital point. EMU will not survive in the longer-term without a system of fiscal transfers – something that German taxpayers are dead set against. It is understandable that thrifty northern Europeans do not want to see their tax contributions used to bail out the more profligate. But without such a mechanism, differences in economic performance between nations will shake the euro zone apart in the same way as fixed currency systems such as the Gold Standard and Bretton Woods ultimately collapsed. The fact that the euro is underpinned by the ECB gives EMU a safety mechanism that neither of the other systems had but, short of the monetary financing of debt, it cannot provide sufficient long-term support to offset the strains in the system.

Whilst Italy clearly does require growth-boosting reforms – it has been one of world’s worst economic performers since 1999 in terms of GDP growth – it is not unreasonable for governments to think about how to use fiscal policy as an active policy instrument once again. We may question whether some of the government’s policies are feasible or desirable (a summary of the policies can be found in this FT article) but politicians are right to ask whether they should continue to operate a fiscal policy which is subordinate to the needs of monetary union.

Perhaps the biggest danger the Italian situation poses is that it really could pose an existential threat to the single currency. Italy is bigger and far more economically important than Greece and cannot so easily be bullied into accepting policies imposed from outside. If, for example, it were to set up a procedure to exit the single currency this would cause investors to be highly concerned about the long-term stability of the project, even if it were never implemented. As it is, Asian investors already do not go near Italian debt – they might be more wary of any euro debt if there is a threat to the currency’s existence.

Italy will not exit the euro, of course: The self-imposed damage this would cause would far outweigh any benefits. But unlike 2012, when the ECB promised to do “whatever it takes” to preserve the single currency, it may be less willing to act as a backstop this time around. Six years ago, the problems were largely the result of prevailing global conditions in the wake of the global financial crisis. Any shocks to the system triggered by conscious Italian policy decisions are unlikely to be met with such unequivocal support, for this would send a signal that countries can ignore the rules with impunity and still be bailed out. Brexit demonstrated that the unthinkable can become reality. We should not be too complacent about the wider implications of Italy’s populist government