24 October 2018

Italy’s budget crisis threatens the Euro


Contrary to conventional wisdom, Italy’s economic problems have little to do with the common European currency, the Euro. Conversely, however, Italy’s draft budget, with a deficit far above Rome’s original commitments, is a ticking time bomb for the Eurozone. And waiting to take decisive action until after the European election next year carries an existential risk to the Eurozone, not to speak of the global economy.

It is true that the Euro can be blamed for the severity of the economic downturn on the Eurozone’s periphery in the early years of this decade, including in Italy. But since then the European Central Bank has moved beyond its narrow inflation-fighting mandate. More importantly, Italy’s woes are primarily fiscal and structural in nature and predate the Euro.

The country’s growth disaster (there has been essentially no real per capita income growth since the end of the 1990s) is the result of a rigid, overregulated economy that protects labour market insiders and prevents innovative companies from expanding. Still, substantial regional differences exist, especially with the country’s North East showing surprising economic resilience and dynamism.

Whilst the Euro’s architects bear responsibility for the fact that Italy entered the Eurozone with a massive debt burden, it is not the fault of the common currency itself that Italy’s government never embarked on a sustained programme of fiscal consolidation. Its debt-to-GDP ratio has barely budged since 2013, and now hovers at 130 per cent.

Italians themselves seem to understand that the country’s economic problems are primarily homegrown. 61 per cent of them support the single European currency, making ‘Italexit’ a distinctly unappealing political proposition.

But that does not mean that Italy’s problems should be of no concern to anybody else. If Italy continues on its current trajectory, it risks sleepwalking into a full-blown sovereign debt crisis. The borrowing costs of both the Italian government and the private sector have been rising since the election as the new government is seeking to reverse the modest reforms introduced by former Prime Minister Paolo Gentiloni and to increase welfare spending. The sustainability of changes is predicated on the government’s ambitious growth projections, far exceeding the 1 per cent current foreseen for 2018 by the IMF.

To be sure, unlike a decade ago, the Eurozone has mechanisms for containing financial distress in member countries. But those are predicated on the enforcement of stringent fiscal rules that Italy, a country of a dramatic size and importance for the European project, has obstinately ignored. It is not clear that the European Commission’s unprecedented red light issued on Tuesday, giving Italy’s government three weeks to rewrite its draft budget, will in itself achieve the desired purpose.

Getting Italy to comply with the Eurozone’s rules might require taking it to the edge of the Eurozone’s cliff, much like in the case of the 2015 bailout referendum in Greece. Notwithstanding a clear ‘no’ vote from the public, Alexis Tsipras’ government capitulated not so much to the Troika, but rather to economic reality. Italy is already receiving budget support from Brussels, conditional on following the bloc’s fiscal rules. Obviously, the EC can – and, at some point – will have to threaten to stop the disbursement of those funds.

Yet, repeating a version of Greece’s scenario is dangerous, particularly at a time when Italian policymakers are oblivious to economic reality. Decades before the term became a buzzword, Italy had pioneered economic populism, Latin American-style. As the economists Rudi Dornbusch and Sebastian Edwards define it in their landmark study, economic populism is “an approach to economics that emphasises growth and income redistribution and de-emphasises the risks of inflation and deficit finance, external constraints, and the reaction of economic agents to aggressive non-market policies.”

Economic populism is characterised by three features. First, a degree of dissatisfaction with existing economic conditions – fully justified in the case of Italy’s sluggish economy. Second, populists’ rejection of constraints imposed by economic reality and dismissing the risks of capital flight or crowding out. Third, their introduction of policies that aim to – and initially succeed in – increase real wages regardless of long-term consequences.

And that is, in a nutshell, Italy’s current situation. The idea that the endgame will be dramatically different in Italy than it was in numerous Latin American countries, as if Europe were somehow immune to the woes of less developed parts of the world, is a dangerous illusion. As Dornbusch and Edwards write, “populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups that were supposed to be favoured”. Let us hope that the Italian government and voters recognise that before is too late.

Dalibor Rohac is a research fellow at the American Enterprise Institute.