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Analysis & opinionJanuary 2 2019

Lorenzo Codogno: Why Italy’s budget brings major sustainability risks

The Italian coalition government's strategy is unlikely to improve the economy in the long run, says London School of Economics visiting professor Lorenzo Codogno.
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Lorenzo Codogno

The soap opera of the Italian budget was still ongoing as 2018 was drawing to a close. Final decisions on fiscal targets are in sight but policy uncertainty is set to spill over into 2019.  

It all began with the March 2018 general elections and the doubling up of electoral promises that emerged from the alliance between the two victorious anti-establishment populist movements: Five Star and the League. In June, they managed to find common ground and formed a government by putting together two unrealistic policy platforms, which independent commentators estimated would increase public spending by more than €100bn – the equivalent of more than 6% of Italy’s gross domestic product (GDP), while the public debt-to-GDP ratio already exceeded 130%.

Their so-called ‘contract for the government of change’ combined the proposals of the two parties in a patchwork of policies that was far removed from the mainstream recommendations of major international organisations, and most economists, on how to address the structural impediments that have held back Italy’s economy for the past 25 years.  

Different antidote

The new political leadership’s simple argument was that past policy recipes have not worked, thus they needed to try something else. The main culprit for poor economic performance was the European fiscal straitjacket: the policies of the economic and monetary union and the euro. The antidote, therefore, had to come from strongly expansionary policies that brought sovereignty back to the country and allowed it to grow. 

With such bold ideas and promises, the two political forces were able to master consensus, boost their outcome at the latest political elections and maintain strong popular support – up until now. According to the government, Italy had to throw out European fiscal rules in favour of policies that ‘give money back to citizens’ – no matter what expert advice and policy experience might say.

In early December 2018, it seemed as if the government was about to backtrack and was prepared to reduce the deficit target for 2019 from 2.4% to 2.2% or perhaps even 2%, in a last-ditch attempt to avoid entering the European excessive debt procedure, despite the already severe damage inflicted on the economy.

However, cosmetic shavings of the budget are unlikely to do the trick, as there are fundamental problems with both the overall budget structure and the government’s strategy. According to the fiscal rules, Italy should have planned a reduction in its structural budget balance by 0.6 of a percentage point in 2019. It would have been possible to plan for a considerably smaller adjustment, equal to only 0.1 of a percentage point, had the flexibility and leeway embedded in the fiscal framework been applied while abiding to the rules. It could have also been possible to introduce some of the ideas from both manifestos (at face value, financially unfeasible) into a more responsible and gradual budgetary plan.  

Expansionary budget

Instead, Italy went in the other direction and, rather than a reduction, it proposed an ultra-expansionary budget worth 1.2 percentage points, based on European Commission economic estimates. Therefore, with the newly suggested shaving of targets, the government would not change course much, and would hardly avoid entering the corrective arm of the stability and growth pact, which envisages close monitoring and a commitment to a well-defined correction plan. 

The government could perhaps try to take time, which would at least avoid the most unpalatable parts of the procedure; that is, the request for a non-interest-bearing deposit and the imposition of a too-strict correction path, with tight deadlines for the so-called ‘effective actions’ that will have to be adopted.

No matter how the negotiation with the EU ends up, it will not change much for the underlying economic policies introduced in the budget – a few tenths of a percentage point of reduced expansion cannot change fundamentally misguided policies. 

There are many reasons for this. The first is that the government is not trying to act in a counter-cyclical way with its proposed expansionary policy: it is actually producing an economic downturn. The government would adopt an expansionary action in contradiction with the cyclical phase that prevailed in the first part of 2018 and with the closure of the output gap (the differential between the level of potential and actual GDP growth). 

Dented confidence

It is true that the Italian economy is now slowing down – and will perhaps enter a recession – but this is only partly due to the weakness common to the whole euro area. Most of it is due to the effects of the government’s economic policies, which have resulted in the widening of yield spreads on government securities and the negative impact on business confidence and investment. The contraction in GDP in the third-quarter of 2018 is testimony to this.

The second reason is more technical. The government did not cancel the safeguard clauses for 2020-21. Net of them, the 2020 deficit will rise to close to 3% instead of falling to 2.1%, as foreseen by the government. Furthermore, the government funded, for 2019 only, two key budget measures: the citizenship income (a basic income for all) and the pension system counter-reform (of the 2011 Fornero reforms). This is misleading, as the two projects are supposed to be permanent. What will happen to those who reach the so-called ‘quota 100’ (when a worker’s number of years of pension contributions plus age totals 100) in 2020 and rightly wants the same treatment as pensioners that were allowed to retire in 2019?  

Moreover, the sought postponement by a few months of the citizenship income might help fiscal targets remain on track in 2019, although likely to the detriment of the following years. The proposed budget would crystallise a higher level of current expenditure by a few percentage points of GDP, with the risk of a substantial increase in the public debt-to-GDP ratio. What future government would then have the political courage to cancel these measures, without the pressure of a new financial crisis?

The third point is about structural budget imbalances. Italy is giving a lot of resources to its pensioners at the expense of future generations. It has one of Europe’s highest pension expenditures relative to GDP and, by reducing the retirement age, the current government’s counter-reform would increase this further. Moreover, from 2008 to today there has been a real collapse in public investment; the government has allocated only crumbs to correct this trend. Finally, the tax burden in Italy is unusually high, reducing the incentive to work and impinging on potential growth. The budget does little to correct these anomalies. Quite the opposite – it accentuates them.

The fourth point is on substance. Reforming active labour market policies in Italy takes years, because these fall under the auspices of regional governments, as decreed by the Italian Constitution. Therefore, in most of the country, the government would inevitably be spreading its 'citizenship income' money with very little control over how it is spent or where it goes, and potentially with loose links to active labour market policies. However, what is most striking, and clashes with the vision that prevails in Europe, is the idea that Italy can grow through debt. “Putting money in the pockets of Italians' could perhaps – had it not already produced a negative reaction in financial markets – give a temporary boost to GDP, but it leaves completely unchanged the underlying conditions that determine the growth potential of the economy.

The final point relates to the huge uncertainty about doing business in Italy that the new government has created by first dismantling part of the labour market reforms introduced in the past, and then with the enhanced risks to financial stability it has generated by budget policies. A strategy to relaunch economic growth on a structural basis is conspicuous by its absence.

Italy’s budget should not pass the evaluation of the European Commission and other European partners. Should a misguided ‘political grand bargaining’ emerge from the negotiation, it would still be hugely problematic for financial markets and negative for the medium-term outlook for debt sustainability and the Italian economy.

Lorenzo Codogno is visiting professor of the London School of Economics and Political Science; founder and chief economist of LC Macro Advisors; and former chief economist and director-general at the treasury department of the Italian Ministry of Economy and Finance (May 2006 to February 2015).

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