Italy’s Budget Isn’t as Crazy as It Seems
(Bloomberg Opinion) -- Europe’s leaders have come down hard on Italy for its plans to increase spending with the aim of boosting growth and helping the poor. What they fail to recognize is that a little stimulus might be just what the Italian economy needs.
The outlook for the global economy is deteriorating more rapidly than forecasters realize. A slowdown in China has hit global trade, European exports are decelerating, and euro-area business sentiment is sharply down. All this can’t help but affect Italy, where industrial production is barely increasing and a recession may be imminent.
This is the context in which one should judge the increasingly strident debate between Brussels and Rome. The new Italian government, led by the right-wing League and the anti-establishment Five-Star Movement, proposed a fiscal stimulus that would cause the budget deficit to rise to 2.4 percent of gross domestic product next year. The European Commission rejected the plan as irresponsible, sparking a showdown that has included an episode of shoe-banging in the European Parliament and a crude exchange of words on Twitter. Amid the discord, the yield on Italy’s 10-year bonds has kept rising.
Yet if the Italian economy is stalling, fiscal stimulus may be the only way to avoid a dangerous recession, which could tip Italy into an unmanageable crisis. Certainly, the EC’s insistence that the Italian government honor its predecessor’s commitment to shrink the budget deficit is completely unreasonable. Austerity will worsen the slump and, hence, increase the government’s debt burden (expressed as a percentage of GDP). This, in turn, will aggravate rather than ease market tensions.
Instead, both sides should focus on the manageable size of a stimulus and the best way to spend the money. Italy faces hard constraints: The country’s debt-to-GDP ratio, at about 132 percent, is already extremely high. It’s thus crucial that the added spending not push the budget deficit beyond the government’s 2.4 percent target. To that end, the government must temper its overly optimistic growth projections, and correspondingly pull back some of its spending, lest the deficit end up larger than planned as a share of GDP.
As regards how to spend the money, the traditional recommendation — that it should go toward infrastructure or other long-lasting investment — might not be an immediate priority. Italian governments have long run primary budget surpluses (excluding interest payments), at a time when growth has been slow and the financial crisis has severely set back sizable segments of the population. As economists from the International Monetary Fund have noted, such persistent belt-tightening creates pent-up demand for tax cuts or public spending to alleviate social discontent. Financial support for low-income families, for instance, could be particularly effective, because the money would go to the people most likely to spend it.
The war of words between the EC and the Italian government leads nowhere. In principle, the commission can impose financial penalties if Italy ignores its recommendations, but even German Chancellor Angela Merkel has recognized that doing so serves only to “bring about insolvency particularly fast.” In any case, such fines are a political non-starter: The heads of government who comprise the European Council, which must authorize any action, will not impose sanctions for fear that their own countries could be sanctioned in the future.
The government’s vague and erratic policies have caused consternation in markets. That said, EC officials’ harsh pronouncements on Italy have also pushed up borrowing costs. Some may see this as a useful source of pressure to keep Italy in line, but it’s playing with fire in a tinderbox. Rising yields and falling bond prices put added stress on already fragile Italian banks, which hold large quantities of government bonds. Distress among banks, in turn, can necessitate bailouts that further worsen the government’s finances. A slowdown in the broader economy will only worsen this dynamic, pushing the weak banks and government finances into a vicious downward spiral.
In such a perilous environment, failure to pursue a constructive discussion could precipitate economic and political disaster. On the other hand, changing the narrative to give legitimacy to a modest Italian stimulus will reassure investors and calm the markets. European officials should quickly reconsider their position.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ashoka Mody is a visiting professor in international economic policy at Princeton University. Previously, he was a deputy director at the International Monetary Fund's research and European departments. He is the author of "EuroTragedy: A Drama in Nine Acts."
©2018 Bloomberg L.P.