Papi’s tax

Tito Boeri 04 October 2011

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Around mid June 2011, the CDS over five-year Italian governments bonds, which measures the cost of insurance against a sovereign default, was about 80 basis points lower than the CDS of the Spanish bonds (bonos) with the same maturity. Today Italian five-year government bonds are insured at 70 basis points above the bonos. Spreads of Italian bonds and bonos vis-à-vis the German Bunds experienced similar developments. From having spreads 70 basis points lower than Spain, Italy has now a spread which is over 40 points higher than Spain.

The two countries have been hit by the same external shocks and, since 8 August, have both been benefiting from the ECB’s support, as the ECB has been massively purchasing the sovereign debt of the two countries in secondary markets. The deterioration of the relative position of Italy vis-à-vis Spain can therefore be attributed to differences in the reaction of the two governments to the credibility crisis. As already discussed on Vox (Boeri 2011), in Italy the government failed to deliver a reassuring consolidation package until the end of August and the one that was finally approved was very much concentrated on tax hikes rather than allowing for expenditure cuts. In Spain, in addition to measures cutting expenditures, several reforms were approved, including pension and labour-market reforms. They also organised road shows of ministers and bankers to New York and other financial capitals to be in touch with markets.

Mismanaging the crisis, one speech at a time

In order to gauge the role played by the domestic policy response in the credibility crisis, we looked at the most important political events taking place this summer in the two countries and we related these events to the evolution of the difference in the spreads, in the spirit of the event-study (and differences-in-differences) literature. This exercise is shown in Figure 1.

Figure 1. Difference in Italy-Spain spread (in relation to the German 10 year bund)

Note: Positive values indicate that Italy’s spread is higher than the Spanish one. See the description of the data points in the appendix.

The first thing to notice is that Italy’s relative position worsened dramatically after Giulio Tremonti, under pressure over a corruption scandal involving his main advisor at the Ministry, stated that he himself was the only politician that could resist pressures for increased public spending: “The political attacks against me are an attack against the country”. This is shown as point 4 in black. This was the worst signal one could possibly convey to markets. A minister caring for market sentiment should have immediately reassured investors about the political turmoil in which he was involved by stating that public finances would be under control regardless of his private situation.

Another event that significantly increased Italy’s spread compared to Spain’s was Berlusconi’s speech to Parliament on 3 August. It had been touted beforehand as a groundbreaking speech, but proved to be void of any new or relevant information for investors. During a credibility crisis, an empty speech is worse than no speech at all. The decision to close the Parliament for six weeks (including a study tour of Italian MPs to Jerusalem), in the middle of the financial storm, just while José Luís Zapatero had announced his intention to spend the entire month of August in Madrid, marked another increase of the relative spread, as it was interpreted as a signal that the Italian government was trying to procrastinate the fiscal adjustment.

All these events moved the relative spread in the direction that one could have expected a priori. The only exception to this is Berlusconi’s announcement, on 8 August, that a new budget package would be approved by 18 August. This statement (point 9 in black) apparently did not have any effect on the spread. A possible interpretation of this failure to reduce the spread is that much more than generic statements of intentions are needed to reverse expectations under a financial crisis. Facts are more important than words, especially when these words come from a prime minister discredited in the international arena. As a matter of fact, the fast approval of the first budget package (point 5 in black), at the beginning of July, improved Italy’s relative position.

In Spain, the pension reform (point 3 in red), the approval of new measures of fiscal consolidation (point 6), and the decision to include a balanced budget rule in the constitution (point 9) all seem to have been rather effective in improving Spain’s relative position. At the end of July, Zapatero’s call for early elections (point 4) did not worsen Spain’s relative spread, which, had been rising 10 days earlier when the Spanish prime minister was under heavy attacks. Even a friendly newspaper like El País asked for his resignation (point 2 in red).

These events and the associated evolution of the relative spread are consistent with the view that the slow and contradictory response of the Italian Government played an important role in the crisis. Communication problems may also have been important. The above quotes from Tremonti suggest that there was no consideration of how investors could react under a financial crisis. A lack of consideration of these communication problems could also explain the differences in the way in which the websites of the Italian and Spanish Ministries of Finance are updated, as well as in the pace at which English translations of new public-finance documents are posted.

The costs of bad government

The above analysis also offers some measures of the costs of bad government under a credibility crisis. If these 110 extra basis points of spread accumulated by Italy with respect to Spain could be entirely attributed to Italian policy failures, then the costs of a bad handling of the crisis would exceed one percentage point of GDP, being of the order of €20 billion at the steady state. Fortunately these costs related to the servicing of the debt do not materialise immediately as the term structure of the Italian debt allows for a relatively long average maturity (about 7.8 years). Thus, Italians can still avoid paying much of this extra tax. However, time is running out, as it becomes more and more difficult to invert expectations, which tend to consolidate when the spread is so high for so long.

The Italian prime minister’s lack of credibility may also be behind the increase in the Italian spread. Studies at the intersection of psychology and economics, based on priming techniques, showed that individuals informed about the amoral details of politicians’ private lives are more reluctant to buy sovereign bonds from these politicians’ countries. This could explain the further widening of the spread after the publication of a new round of the prime minister’s private phone conversations. To gauge the importance of this effect, just ask yourself: Would you ever buy a used car from someone whose private life is visibly in contradiction with the principles stated repeatedly in his public life? As long as Silvio Berlusconi is prime minister of Italy, investors will perceive him as the main salesman of Italian bonds. Part of this 110 basis points tax can be traced to Berlusconi’s conduct. We may call it Papi’s tax as “papi” was the nickname used by the 17-year-old girl involved in one of the very many sex scandals.

References

Boeri, Tito (2011) “Italy's confidence crisis: Bad policies from bad politicians” , VoxEU.org, 17 August.

Appendix. Events affecting the bond spread

ITALY

  1. Over the weekend Marco Milanese announces his resignation – June 26th
  2. Rumours on Tremonti’s resignation – June 27th
  3. The “Lodo Mondadori” is introduced in the budget package. Napolitano refuses to sign – July 4th
  4. Milanese: chaos and quarrels in the government coalition. Tremonti “the attacks against me are damaging the country” – July 8th
  5. Fast-track approval of the budget package, interventions anticipated to 2012 under pressure from Napolitano – July 13th
  6. Budget package approved – July 15th
  7. Berlusconi’s empty speech. 6 week holidays for the parliament – August 3rd
  8. Tremonti and Berlusconi squabble – August 4th
  9. Announcement of anticipation of the budget package. The parliament reopens – August 5th
  10. Budget package approved – August 13th
  11. The Government backtracks on reforms. Extra tax on higher incomes? VAT? Pensions? – August 29th
  12. Merkel on Italy and Greece: the situation is fragile – September 5th
  13. Budget package approved by the Senate – September 7th
  14. New phone taps are published – September 14th
  15. Standard & Poor’s downgrades Italy – September 18th

SPAIN

  1. New spending rule approved. Public spending linked to economic growth – July 14th
  2. El País asks for Zapatero’s resignation and for early elections – July 18th
  3. Pension reform approved – July 21st
  4. Zapatero resigns. Elections announced for November – July 29th
  5. Zapatero announces postponement of holidays – August 3rd
  6. New measures for fiscal consolidation – August 19th
  7. Growth measures. VAT reduced on housing, training contract for youngsters – August 23rd
  8. New labour market reform – August 26th
  9. Budget Balance in Spanish Constitution – September 2nd
  10. Spain announces that the deficit on regions will be higher than expected – September 8th

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Topics:  Europe's nations and regions International finance

Tags:  Italy, Spain, spreads, bonds

Professor of Economics at Bocconi University, Milan; Scientific Director of the Fondazione Rodolfo Debenedetti and the founder of LaVoce. CEPR Research Fellow