Italy and the Eurozone: it's time to inflate

Paolo Manasse interviewed by Viv Davies, 2 Dec 2011

Paolo Manasse talks to Viv Davies about Italy and the Eurozone crisis. They discuss the economic and political challenges currently facing Italy, how a eurozone fiscal union might work in practice and the role of eurobonds. Manasse explains the trade-off between addressing sovereign debt in the peripheral economies and establishing broader financial stability across the Eurozone; he maintains that an expansionary ECB monetary policy is an important part of the solution. The interview was recorded on 30 November 2011. [Also read the transcript]


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Viv Davies: Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Center for Economic Policy Research. It's the 30th of November 2011, and I'm speaking to Professor Paolo Manasse of the University of Bologna about Italy and the Eurozone crisis. Professor Manasse presents his views on Italy's immediate priorities and explains the political and economic challenges the country now faces. We discuss the prospect of fiscal union in the Eurozone and the role of the European Central Bank. Manasse is of the opinion that the Eurozone requires an expansionary ECB monetary policy and an inflationary environment in order to overcome the crisis.

I began the interview by asking Paolo what he thought were Italy's immediate priorities and the extent to which he considered Mario Monti's government were committed towards addressing them.

Professor Paolo Manasse: I think their priorities are right, in the sense that Italy definitely needs to restore growth and, at the same time, to try and consolidate its budget. And I think that Mario Monti understands very well that it has to do both things at the same time to avoid a downwards spiral of the economy that would lead to higher deficits and to further fiscal stress, and so on. There are two difficulties in that. One is a political difficulty, and one is an economic difficulty. The economic difficulty is that the measures that Mario Monti is now going to implement on the structural reform side are supply side measures. And this supply side measure - like cutting pensions and liberalization of service and goods market and so on, and liberalization of the labor markets and so on and so forth - now, this supply side measure typically has short term negative effects on the economy. For example, if you cut pensions, you not only have budget cuts, which are deflationary, but then, only over time, you may have positive effects, and then people have less money to spend and so on and so forth.

If you add to this structural reform - which may have negative effects in the short run - the fiscal consolidation, then there is a risk that not only the economy would shrink, aggravating the budget, but also that you may run into some sort of deflationary situation, with prices falling, because you have no downward shift, so to speak, in the aggregate demand, and then aggregate supply shifts up, and, as a result, economic activity tends to fall in the short run and prices tend to fall as well.

Now, both these things may aggravate, very much, the fiscal outlook, because you get it at the same time, you have lower revenues, and you may even have an increase in expenditure for unemployment benefits and so on. And even more seriously, if you get to the situation where you have negative inflation, which is not unlikely, then real interest rates go up, and that, coupled with negative growth, may make the debt dynamics explode.

The economic risk is this - that in the short run fiscal consolidation plus structural reform may not only depress the economy but also imply a negative spiral of prices. The political risk is that, if that happens, I think Berlusconi may be tempted to come back and, that is to say, may withdraw his support to the Monti government and present himself as the kind of paladin of growth, and that would be a disaster. That would really be a disaster.

Viv: OK. You mentioned fiscal consolidation. Just a few days ago, Angela Merkel and Nicolas Sarkozy announced that they would be proposing modifications to the Eurozone treaties, in order to improve Eurozone governance and to ensure greater integration and convergence among the 17 members. Essentially, they are proposing a move towards Eurozone fiscal union. Are you in favor of that?

Paolo: Yes. But I think one has to be clear what that should mean. If that means a kind of more centralized fiscal policy in which, for example, there is some sort of veto power of European institutions on national budgets, I think that would be a good idea. And then I think what could be reasonable, not to completely give up national sovereignty to the EU, would be to get to a situation like the budget process as it used to be the UK, for example that is, a two stage budget process in which you have a first stage in which the aggregate measures, the difference between spending and revenues, is fixed, then a second stage in which you argue about the composition of spending and taxes. Now, the first stage should be, in a sense, delegated to some sort of European fiscal powers, and it would set the overall, macro outlook. And then, you should leave to the parliament - because you don't want a national parliament to be totally expropriated - you should let the national parliament to decide about the composition of spending and taxes. That may be a reasonable solution, although it would mean just delegating a lot of sovereignty to upper European levels. The problem is that Germany seems to think that if everybody shrinks, problems will be solved. But that is not, clearly, going to be the case.

Viv: What are your views on President Barroso's recent proposal of introducing common Eurozone bonds, or, as he called them, stability bonds, as a way of resolving the debt crisis? Is it a short term solution?

Paolo: Well, that should be a part of the fiscal framework, in the sense that I have written, also on Vox, an objection to the idea of eurobonds, in the sense that a bond has a value and an equilibrium only insofar as people think that it will be eventually repaid. Now, to be eventually repaid, a euro wide bond needs to be repaid by surplus countries. Now, clearly, no surplus country is going to repay a deficit country's debt without having control of the financial situation of those countries. There is no way the eurobonds will be approved, in my opinion, unless it's a part of some sort of fiscal package in which you have, really, power of countries running surpluses to decide the fiscal policy in countries who run deficits, because otherwise no one will be willing to waste its own taxpayer money to finance other countries' expenditures.

The two things could work together, and only together, to be politically viable. It could be a good idea, only insofar as it comes together with a fiscal union of some sort.

Viv: What about the European Central Bank? Do you think the ECB should play a more prominent role in the crisis and effectively become the lender of last resort?

Paolo: I think the short answer is yes. The longer answer is that the BCE is now facing, apparently, a tough trade off, which is a trade off of monetizing the debt of peripheral countries and potentially adding to inflation. That's one part. The other part is the financial stability of the Eurozone at large. This is the sort of trade off. Clearly, one can understand, given the way in which the ECB was born with the German model of the Bundesbank, that Germany doesn't want to give up their role of inflation guardian, so to speak, but this ignores the other part of the trade off. If the other part of the trade off becomes prominent and there is a risk, as it is now, of financial collapse of the Eurozone, then I think anybody, reasonably, would think that you can accept more inflation.

Also, I think this trade off is a theoretical one, in a sense, because as of now the main risk, as I said before, I think, is the kind that, eventually, Europe may spiral down into deflation. This is because, if every country or many countries at the same time are at the same time adopting a fiscal consolidation and a supply side measure, the effect of those, as I argued before, are going to be to reduce inflation and possibly to get to a situation where you have stagnation plus deflation.

And so, in a sense, this is already…what we also observe right now is that we are running into problems of liquidity, very sharp, very huge problems of liquidity in banks. The solution to that would be, really, to have a very expansionary, QE type monetary policy by the BCE, not only providing liquidity to banks at zero interest rates but also be willing to buy debt. Basically, what we need is more inflation right now. We badly need more inflation in Europe. That would take care, also, of a part of sovereign debt problems by reducing the interest cost and real value of debt.

And so this trade off I was speaking about before is a theoretical one, because just now more inflation would be beneficial, both to the sovereign debt crisis and to financial stability, in a sense.

Viv: Current market signals seem to indicate that investors are losing confidence in German bunds. Also, we saw Italian bonds, yesterday, short term yields rising to eight percent. How serious do you think these problems are?

Paolo: I think they are very serious, because I think the result of our analysis that I alluded to before pointed to the fact that no one would be unaffected by an eventual collapse, for example, of Italy. We already seeing, and have been seeing that for some time, even looking at the EFSF's issues of debt, they have been increasingly going up in terms of bond yields. Now we're seeing that on Germany, whose bonds have begun paying more than UK gilts, for example. I think there are a couple of ways to explain that. Possibly the most convincing is that, come the question of contingent liabilities, Germany eventually may be asked to pick up the bill to some extent. And then, if there is a big crisis, like a breakup in the Eurozone, it's also going to be a problem for Germany if, say, a number of countries, like Italy, exit the euro and devalue sharply, with respect to the new euro or new German mark, or whatever. That would be very tough for Germany in the sense that firms in Germany would suffer from huge competition from countries who devalued in real terms.

So whatever happens, Germany may be affected, and the budget may be affected by saving banks that have invested in Italy, for example, or a few firms that faces tough competition if Europe breaks up and so on. I think, eventually, the crisis will spread to Germany as well if nothing is done in the meantime.

Viv: Italian citizens have, this week, been called upon to be patriotic and buy up government bonds that have been shunned by foreign banks. Is this a realistic way forward?
Paolo: The answer is no, for a number of reasons. First, this is a "you beef up the base," a trick thing, because the one that took place yesterday was not on a first issue of the debt but was debt from the secondary market. Italian houses have been buying debt that already had been issued, so what really happened is that they took debt out from the balance sheets of banks. That's why banks were very favorable to the speech today, because they managed to download the bad assets to the houses. And also, from a point of view of looking at the numbers, housesholds hold something like 14 percent of the Italian debt, so it's very unlikely that this sort of measure would do anything, either to spread or reduce our dependence on foreign creditors, which is about 43 percent of the debt.

Viv: Finally, Paolo, many economists are of the opinion right now that the future of the euro is entirely in the hands of politicians and there is no more that economists can say or advise that hasn't been said already. Regardless of that, do you have a quick solution that you would provide right now, in a nutshell, regardless of whether the policymakers are prepared to listen or not?

Paolo: Well, yes. I think it should have at least the following ingredients. One is, everybody wants more fiscal union, and I think a two step budget procedure may be a possible solution, in the sense that you have more powers at the centre, but it leaves powers to the national government to decide about the composition of the budget, the size of the budget are decided elsewhere, or at least there is a veto power. As for at the Eurozone level, the second part may be a eurobond, when you have this guarantee that, eventually, if you are running deficits and you are kind of under control, you lose your fiscal independence, and that would take care of the fiscal situation. There would be a larger load for the ECB, possibly together with the IMF. And if there are legal problems in terms of the treaty, then some solution, like the ECB lending to the IMF, which may, at that point, take the role of lender of last resort, may be a possible solution.

As far as the situation of countries which are already insolvent, Greece being the obvious example, I think the orderly restructure should be done without other, to reach a station, so to speak, so without losing more time. Such countries should default in an ordinate way and then just move on from then.

Viv: Paolo Manasse, thanks very much for taking the time to talk to us today.

Paolo: Thank you very much.

Topics: Europe's nations and regions, Financial markets, Politics and economics
Tags: debt restructuring, default, ECB, Eurozone crisis, Italy

Paolo Manasse

Professor of Macroeconomics and International Economic Policy at the University of Bologna