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Published 08:37 September 28, 2018
Updated 12:54 September 28, 2018
Will Italy destroy the Eurozone?
Euro-critical discourse is mainstream in Italy. The current government is a coalition that encompasses left and right traditions of sovereigntist politics.
The economy is the epicentre of this discussion.
Until earlier this week, the Italian government held up flagship policy commitments that included more redistribution and a smaller tax burden. All that spooked markets, with sovereign bond yields doubling since May 2018. International credit rating agencies and markets are adding to the pressure. The European Commission, once again, calls for fiscal discipline.
Amid this pressure, political and profoundly economic, New Europe sought the help of an economist to understand the Italian mindset. Sergio Cesaratto (SC) is a Professor of International Economics at the University of Siena, Italy. He specialises in Monetary and Fiscal Policy of the European Monetary Union (EMU).
Professor Cesaratto is a significant contributor to Post-Keynesian discourse, focusing on growth and innovation theory, pension reforms, monetary economics and the European crisis. He is deeply involved in the Italian and European debates on the Euro crisis and has recently published two successful books in Italian on this subject.
Committed to political tradition of the Italian democratic left, Cesaratto views the nation-state as the natural playing ground for a democratic conflict and compromise over income distribution. For that reason, he is also a frequently cited source in what is now a mainstream Euro-critical discourse in Italy.
New Europe (NE). Japan has a 250% debt to GDP ratio, the Greece 180% debt-to-GDP, and Italy 132%. When do investors worry?
Sergio Cesaratto (SC). A natural level of the public debt/GDP ratio does not exist, of course. Two factors are often evoked to assess the sustainability of the public debt:
- its denomination, in the national or foreign currency
- whether is mainly held domestically or by foreign creditors.
A debt denominated in national currency and held by residents is generally considered safe. That is the case in Japan. Notably, in Japan, the primary bond holders are the central bank and the domestic financial system who, expectedly, will not speculate against their government.
That the Japanese public debt is held domestically is not surprising. Since Japan traditionally maintains external trade surpluses, the economy is not dependent on foreign loans. Therefore, its debt is denominated in Yen and the government can rely on the Bank of Japan as a buyer of last resort, which reassures private holders. That also means interest rates – and bond yields – are under control.
This virtuous circle maintains the debt-to-GDP ratio stable. If Japan’s debt were denominated in a foreign currency and held by non-residents, the economy would be exposed to waves of financial panic. In the case of Greece, Spain and partially Italy, there is no central bank that can act as a buyer of last resort.
The problem with the Italian public debt is its denomination in a foreign currency (the euro) and the lack of a national central bank, which comes hand-in-hand with lack of control over capital flows. But, unlike Spain, Italy does not have significant foreign debt exposure.
NE: How did Italy reach this level of debt? Do you believe this is a case of profligacy or is there a more systemic issue at play? (300 words).
SC. The big jump of the Italian public debt took place in the 1980s.
The Seventies had been a period of social conflict that led to price instability. A flexible exchange rate, however, preserved the external competitiveness, while an accommodating policy by the Bank of Italy avoided a rise in the public debt. At the end of that decade, the Italian élite opted for a new policy regime based on fixed exchange rates (the EMS) and an independent central bank.
The loss of external competitiveness led, however, to problems of aggregate demand and, as Stiglitz has put it, countries with persistent or expanding current account deficits are often obliged to run fiscal deficits to maintain aggregate demand: ‘Without fiscal deficit, they will have high unemployment’, Stiglitz wrote in 2010.
These fiscal deficits and the high-interest rates necessary to support the parity in the EMS led to the explosion of the public debt/GDP ratio. The attempt to impose “foreign discipline” lies at the foundation of the Italian debt problem.
Taking some breathing room after Italy’s exit from the EMS in 1992, Italy repeated the mistake of “tying her hands” by participating in the European monetary union. In the first decade of the euro, Italy used the lower interest rate and a contractionary fiscal stance to reduce the debt/GDP ratio from about 125% to 100% at the cost of stagnating domestic demand and, therefore, investment and productivity growth.
The loss of external competitiveness – also due to the German neo-mercantilist policies – did not help. As a consequence of the financial crisis and, more importantly, of the delayed intervention of the European Central Bank and austerity, the debt ratio jumped again at 130%.
Italy desperately needs a relaunch of domestic demand through an expansionary fiscal stance. This requires that interest rates remain comparable to French levels. To this end, measures can and should be taken at a European level.
Targetted ECB support on public debt management, as proposed by Professor Paolo Savona in a recent memorandum, would be necessary. Italy has practised fiscal rectitude since 1991, more than Germany.
“It is the interest rate, stupid!” to paraphrase Clinton.
NE: Why did the cost of Italian borrowing double since May? What is it about the Minister of European Affairs Paolo Savona that scared credit-rating agencies, the President (Sergio Mattarella), and the European Commission?
SC. Paolo Savona is an experienced and moderate economist. His recent memorandum advanced reasonable proposals that will, of course, be ignored by Berlin.
Europe’s problem is the German élite’s mindset, informed by a mercantilist model that insists on domestic wage and fiscal moderation. Dubbed by the historian Carl-Ludwig Holtfrerich as “monetary mercantilism,” this German model was initially championed by finance minister (and later Chancellor) Ludwig Erhard in the 1950s.
In sum, the problem of the European economy is Germany, not Italy!
President Mattarella belongs to the Italian élite that is pro-European at all costs. They do not really have confidence in the country’s sovereign capacity and believes that Italy, outside Europe, would be lost. I argue that European (or German) discipline is primarily responsible for the surge in public debt, economic stagnation and decline.
Financial markets are scared because investors fear that Italy can be derailed as a result of fiscal expansion without European backing. So the spreads BTP/BUND climbed.
You see, France has a very low spread against the BUND, around 35 basic points, while Italy has well over 200 points. It makes an enormous difference. Macron can do deficit spending without increasing the debt/GDP ratio; a similar deficit would rise the Italian ratio. Again, that is a question of interest rates. Italy needs a reliable government, trusted by our partners who, in turn, should ensure Italian interest rates fall.
We are, however, in a vicious circle in which the lack of trust in Italy generates less trustworthy governments. However, even with “reliable” governments, I believe that Europe does not have the foresight to lend a helping hand.
NE: Lega seems to be pushing the economy towards a business-friendly model, favouring a generous reduction in the cost of doing business: a two-tier flat tax (15-20%) and no VAT tax hikes. The Five Star Movement seems to be pointing towards a demand-driven stimulus, with a guaranteed minimum income (€780) and a rollback of pension reforms.
Two questions here:
Can Italy do all that and retain a budget deficit below 3%, or even at 1,6% as advocated by the Italian Minister of the Economy Giovanni Tria?
SC: As I said, If Italy had the same interest rates on the public debt of France, this would allow a moderately expansionary stance consistent with the stabilisation of the debt ratio.
In my view, the position of the Italian government should be the following: Italy has a good record of fiscal rectitude since 1991 (a positive primary deficit); were it not for misguided ECB and EU policy, the debt-to-GDP ratio would be at the French level (100%). Anyhow, 130% does not make much difference. Why should not Italy receive European support in exchange for a commitment to the stabilisation of the debt ratio at the present level? That is reasonable.
Unfortunately, Berlin will say nein. With a change in the direction of the ECB and a more right-wing German government, things might even get worse. Italy should then be prepared for an exit. The main problem of an exit is possible Franco-German retaliation. So much for Matarella’s European dreams.
NE: As an economist, which policies do you think would help Italian growth more? Do we need both MS5 and Lega measures?
SC: Italy does not need a flat tax, but a campaign fight against tax-evasion.
Of course, when possible, lower tax rates are desirable, but this is not the priority. The economy must prioritise households below the poverty line. However, I would prefer an “employment plan” rather than a generalised universal basic income. Infrastructures and education are also priorities.
NE: Italian, Greek and Spanish banks have an enormous pile of non-performing loans. In part, this is due to people being unable to pay their mortgages. In part, it is because small and medium businesses are no longer profitable. Is fiscal discipline helping banks to reduce the size of their non-performing loans?
SC: NPLs are clearly the result of austerity.
Therefore, a continuation of the same policies is not helping. Moreover, the lack of a central bank umbrella on the public debt and rising interest rates also affect the cost of credit to Italian households and companies.
Italian banks do their job of supporting the economy. The big German banks are speculative institutions and among the protagonists in the US financial crisis. They are still full of toxic assets. The German public opinion should be better informed about this. As Adalbert Winkler points out, German economists complain when Draghi moves to support the Italian public debt but say nothing when the German government bails out its troubled banks.
The present fall in the value of Italian government bonds has also negatively affected the balance sheet of Italian banks. Of course, to oblige them to get rid of them would be suicidal.
NE: The European Central Bank will end its bond-buying programme in December 2018. How will this affect the Italian economy?
SC: All things being equal, not much will change: the Italian treasury bonds are already highly (unjustifiably) penalized. Of course, if there was a speculative attack on the Italian debt, having a Draghi or a Trichet would make a difference. In this regard, it seems that even Germany would like to avoid a divisive new president like Weidmann.
However, the reforms of the European economic governance proposed by Berlin are destabilizing. The intention is to strip the European Commission of the power to monitor and sanction the observance of fiscal rules, surrendering them to a European Monetary Fund and eventually to the markets. This leaves little room for political negotiation which, ultimately, is suicidal. No Italian government can sign up to such reforms.
NE: Will Italy destroy the Eurozone?
SC: My spontaneous answer would be “I hope so.”
I feel the Eurozone is an anti-democratic and foreign cage. To some degree, this also applies to the EU, which is a neoliberal institution. For instance, the EU prohibited state-supported industrial policy and forced Italy to privatize its state-owned industry, mostly to foreign companies, which often dismantled them.
Italy will destroy the eurozone if Brussels pushes the country towards its destruction by market speculation and austerity policies.
Who is destroying the Eurozone and global trade: Italy or the German external and fiscal surpluses? My fear is that even if faced with a financial attack and a Troika, Italy will not rebel against the diktats and allow a new Mario Monti to massacre the country in the name of Europe. One candidate is Enrico Letta. Unfortunately, the Greek tragedy teaches us that the resilience of ordinary people to economic hardship (and stupidity) is infinite.