“Italy plans an obvious significant deviation of the recommendations adopted by the Council under the Stability and Growth Pact for 2019.”
This was the clear message that Pierre Moscovici, Commissioner for Economic and Financial Affairs, sent the Italian Minister of Finance and Economy regarding the budget proposal elaborated by Italy’s coalition government for fiscal year 2019. In a letter sent last October 18, the European Commission made clear that the proposed budget involves a clear violation of the Stability and Growth Pact, a mechanism designed to curb the uncontrollable desire of European politicians to increase public spending.
The reaction to this decision came swiftly. After a press conference held by Moscovici to explain this decision, Angelo Ciocca, a MEP from the Lega Nord, took off his shoe and trampled on Moscovici’s papers to show his disagreement with the decision adopted by the Commission. Unfortunately for Italian populists, eccentricities don’t change the reality of numbers. The 2.7 percent rise in government spending proposed by Italy’s government would increase the cyclically-adjusted deficit by 0.8 percent of GDP. Since the European Commission expects Italy to reduce its deficit-to-GDP ratio by 0.6 percent in 2019, the deviation amounts to almost 1.5 percent of GDP.
It seems obvious that Italy’s budget proposal is just a provocation: the Italian government knew beforehand that it would never be accepted by the Commission. However, from a Keynesian perspective, this budget makes perfect sense: what Italy needs right now is an expansionary fiscal policy that boosts aggregate demand and expands output, bringing about economic growth. Because borrowing costs in the Eurozone have gone down dramatically for governments since Draghi’s famous “whatever it takes” speech, this seems the perfect moment for the Italian government to incur budget deficits and provide a decisive impulse to the ailing Italian economy.
Nonetheless, the above analysis has some flaws. First, it doesn’t look beyond the short term. Expansionary fiscal policies normally lead to increasing output, whereas fiscal austerity tends to be contractionary. However, this isn’t always the case. Ireland, Spain or the Baltics are good examples of how a serious commitment to fiscal consolidation coupled with structural reforms can lead to economic growth in the mid and long term. Second, the ECB will terminate the asset purchase program in December this year, which means that sovereign bond yields are expected to increase in the following months. Finally, it excludes the negative effects of high-debt levels and economic uncertainty on interest rates and investment.
The mechanism whereby fiscal expansions can end up being contractionary is brilliantly explained by economists Olivier Blanchard and Jeromin Zettelmeyer in a recent article entitled The Italian Budget: A Case of Contractionary Fiscal Expansion? Assuming a fiscal multiplier of 1.5, they estimate that a 0.8 percent increase in structural deficit would lead to 1.2 percent increase in GDP. Yet this increase would be offset by the impact of increasing interest rates on bank lending and, as a result, on aggregate investment.
Since April, the yield of the 10-year Italian bond has gone up by 1.6 percentage points due to investors’ concerns about the fiscal policy of the new coalition government. Given the close relationship between bond yields and banking lending rates as well as the heavy exposure that Italian banks have to sovereign debt (increasing bond yields impact negatively on the capital buffer of banks), it is expected that bank lending falls, with the subsequent impact on investment and output.
Using the available empirical evidence, Blanchard and Zettelmeyer conclude that output could decrease by around 1.3 percent, which means that the fiscal expansion planned by the Italian government would cause GDP to fall by around 0.1%. If bond yields continue to rise, a possibility that cannot be ruled out as shown by the irresponsibility of the Italian populist government, the impact could be even higher.
If Italy wants to go back to the path of strong economic growth, it should abandon populist experiments, balance the budget and undertake structural reforms aimed at liberalizing the Italian economy, which now ranks between Kyrgyzstan and Serbia in terms of economic freedom. Otherwise, it is doomed to follow the path of Greece, although with a significant difference: the EU cannot afford to bail out the third largest economy in the Eurozone.