Three fiscal consolidation packages in six weeks—each more ambitious than the last—have failed to prevent a credibility crisis that has doubled the Italy’s risk premium. The problem was that none of the packages addressed the fundamental shortcomings of the first one—the one that started the credibility crisis. We saw partial remedies for relatively minor deficiencies. Such failings bring to mind the old axiom: Errare humanum est, perseverare autem diabolicum (to err is human but to persevere is diabolical).
At least the sequence of recent events in Italy will serve to inform other Eurozone members about the consequences of procrastination—and the effects of external pressure and the ECB conditionality on governments.
The causes of the confidence crisis
Italy’s latest turn has attracted plenty of attention (see for example Dadush and Stancil 2011 on this site). There are two factors behind the Italian public debt crisis:
- slow growth, and
- budget problems, specifically the failure to control primary non-investment public expenditures (which has grown faster than inflation).
While Italy experienced relatively mild external shocks since 2007, as it avoided the boom-bust housing cycle and had no major banks failures, its slow growth is due to structural problems. Its institutional impediments to growth, as is well-known, lie in the labour and product markets. Zero-budget reforms have been devised (see the extensive debate on these issues and proposals on lavoce.info since 2002) but not implemented.
Any serious adjustment programme needs to tackle these issues. Governments must prove they are able to cut down permanently non-investment public spending over GDP and carry out reforms aimed at increasing potential output growth.
In addition, the adjustment must be equitable. This is a matter of political sustainability, particularly important if the adjustment is perceived as being imposed by international organisations. The Greek experience is enlightening in this respect. The package imposed by the “troika” of the ECB, EU, and IMF was initially supported by a majority of the population, while now only less than one Greek voter out of five is in favour of the reforms because they failed to tackle tax evasion, a corrupt public administration, and the privileges of well-connected groups.
Shortcoming of the first Italian consolidation plan
The first Italian plan—adopted at the beginning of July 2011—was a de facto postponing of any serious adjustment until after the 2013 elections. In 2012, the year in which elections will most likely take place if the thin majority currently supporting Berlusconi erodes away, the plan actually envisaged an increase in public spending of some €4 billion. Another €15 billion (out of a total of €40 billion) was to be collected later via a “fiscal and social assistance reform”, without any detail being provided on the nature of these reforms.
No measures were taken to foster growth—no structural reforms, not even small measures locally increasing competition, eg in the liberal professions.
The package was not even equitable. For example, it called on Italian families to pay higher taxes, but the very first draft included a measure that would have allowed one of the nation’s richest men—Prime Minister Berlusconi—to receive de facto a transfer of some €560 million (by letting his business group avoid a legal penalty related to the Mondadori publishing company case). As the average family’s real disposable income fell by more than 3% during the Great Recession, this struck me as inequitable to say the least.
The second and third plans
The second plan was approved two weeks later under rapidly deteriorating government-bond spreads. This new plan coped with the problem of the missing €15 billion, introducing a “safeguard clause” forcing the cut of a number of tax deductions to poor families in case the promised “fiscal cum assistance reform” had not been carried out. It also allowed for some adjustment in 2011 and 2012. Finally, it increased the overall size of the adjustment to be achieved by 2014 to €48 billion from in the initial plan’s €40 billion.
The plan, however, did not increase the contribution of expenditure cuts to the adjustment. In the second package more than 2/3rd of the adjustment was on the revenue side. Once again it featured no pro-growth measures. Nor was it equitable. The yearly pay of MPs was actually increased by €12,000 with respect to the previous version of the package.
The third plan—proposed two days ago and passed by decree—is marked by many missing details concerning the size of the different measures.
- The impression is that it is over-optimistic as it may fail to attain its new fiscal consolidation targets for 2012 and 2013 (requiring another €45 billion to be collected in these two years).
- It accounts for neither the worsening macroeconomy, nor of the recessionary effects of the package itself.
Three features of the package are clear already at this stage.
- First, the contribution of taxes, as opposed to expenditure cuts, further increases.
There is also no structural spending cut, besides a very modest (it could reach at most €1 billion) reduction of the so-called costs of politics. And these are to materialise only in the second half of 2013.
- Second, no growth-enhancing measures are envisaged except some (modest and largely undetermined) incentives for local Governments to sell public assets.
At the same time, further increases in payroll taxes are introduced making the recovery more problematic. The Italian labour tax wedge is already among the highest in the OECD.
- Third, it is likely to be perceived as unfair by the electorate.
Italy has large tax evasion on income and very low taxes on assets, notably house ownership. These are only very mildly taxed in Italy (some 2% of total fiscal revenues compared with 10-20% in the UK and US). As little is done to remedy this, the third package is in effect asking those who pay taxes to cover the missing contributions of those who evade taxes. (Finance Minister Tremonti has a long record of fiscal amnesties.)
Nothing was sufficient to induce the ruling coalition to tackle the key shortcomings of the initial plan.
- Not the opportunity of 3 consolidation packages;
- Not the dramatic credibility crisis raising the yields on Italian 10-year government bonds well above 6% (creating serious liquidity problems for Italian banks that own large amounts of “toxic” government securities);
- Not the explicit request of the ECB (embedded in a letter of the current and next Presidents, Jean-Claude Trichet and Mario Draghi, laying out conditions for the purchase of Italian state assets).
It is as if Berlusconi and Tremonti suffer both from the “last cigarette” syndrome of Zeno in Italo Svevo’s masterpiece Zeno's Conscience.1 The fact of the matter is that the key people in the current government do not believe in structural reforms and have very short horizons.
Politicians who understood Italy’s structural problems would take advantage of the times of “extraordinary politics”. They would use, if needed, the international organisations as scapegoats while cutting public spending in pensions (currently absorbing some 50% of current primary expenditure) and public administration.
But neither Berlusconi nor Tremonti believe in the growth-enhancing properties of these reforms. This is why they keep postponing and buying time—and in doing so, just making things worse. Their goal, it seems, is simply their own political survival regardless of the cost to Italy. This is the reason Tremonti stated that without him the fiscal consolidation process was at risk—the worst sort of signal to send to markets (and fortunately not true). It is also the motivation behind Berlusconi repeatedly blaming unpredictable external factors—as if Italy could not do anything to save itself. This is another wrong signal to send to markets that do not believe in an escalation of the European involvement in the Italian crisis and consider Italy to be “too big to be saved”. Fortunately this claim is also ill-founded: Italy can make it even without further involvement of the EU.
It is clear at this stage that the problem of Italy is not only one of policies. The credibility problem includes those who should carry out economic policies. It is a problem of bad politicians over and above a problem of bad policies. And external pressure and conditionality can do little about it.
A broader lesson of the crisis is that the conditionality of the ECB is very weak. While it can in principle stop purchasing government bonds if it considers the consolidation package insufficient, the threat of interrupting open market operations is just not credible. The intervention of the ECB must be perceived by markets to be unconditional in order to be effective in contributing to reverse expectations as to a country default risk. This is an additional reason why the ECB cannot substitute for stronger fiscal co-ordination in the Eurozone.
Dadush, Uri and Bennett Stancil (2011), “Italy: Call in the G20?”, VoxEU.org, 8 August.
1 When a doctor tells Zeno that he must abstain from smoking, he smokes his "last cigarette" many times becoming plagued with "last cigarettes", deciding to quit on days of important events or the harmony in the numbers of dates, but each time, the cigarette fails to truly be the last.