Thomas Fazi – Lessons from the Italian budget crisis

The tensions and contradictions within the European project, from Brexit and the Pasokification of social democracy to the rise of the right and the rollback of social Europe present very serious challenges to building left power across Europe. In this week’s guest post, journalist and filmmaker Thomas Fazi turns our attention towards the recent budget standoff between the Italian government and the European Commission. He argues that this example serves to highlight the arbitrary and undemocratic nature of economic governance within the eurozone and the EU more broadly. This, he concludes, may herald the ‘slow-motion implosion’ of the EU, with potential strategic lessons for the European left.

Thomas Fazi is a writer, journalist, translator and researcher.

Cross-posted from the Rosa Luxemburg Stiftung

Future historians will probably look back to the recent standoff between the European Commission and the Italian government as one of the crucial turning points in the European Union’s slow-motion implosion.

The facts, by now, are well known. In mid-October – as per European rules, which require national budgets to be approved by the European Commission – the Italian government submitted its 2019 draft budget to the Commission for review. The government’s fiscal plan foresaw a 2.4 per cent fiscal deficit for 2019, which would then be reduced to 2.1 in 2020 and 1.8 in 2021. The proposed deficit for 2019 was the same as Italy’s last recorded deficit and was lower than the average deficit recorded over the 2013-17 period, which was equal to 2.7 per cent.

In itself this was far from revolutionary. However, it represented an increase over the budget for 2019 proposed back in March of last year by the outgoing government, which planned an estimated decrease in the government deficit to 1.6 per cent in 2018, 0.8 in 2019, and to a broadly balanced budgetary position by 2020.

As expected, the European Commission rejected the new budget, threatening to activate its infamous excessive deficit procedure, which can lead to a fine of up to 0.2 per cent of the concerned country’s GDP. After much posturing by the Italian authorities, the government partially caved in to the Commission, agreeing to a deficit target of 2.04 per cent for the coming year (yes, they simply added a zero in, probably in the hope of fooling a few of their supporters back home).

To evaluate the reaction of the European institutions to the Italian budget, we should start by looking at the budget itself. I will focus solely on the size of the budget – which, after all, is what all the fuss was about – and not on its content. A first point to note is that, contrary to what various commentators have argued, the proposed budget was definitely not an expansionary budget – if anything, it was less contractionary than the one drafted by the previous government. In fact, excluding interest payments on the existing stock of public debt (equal to around 3.5 per cent of GDP), the government’s fiscal plan foresaw a primary budget surplus of a little over 1 per cent of GDP (which has now been raised to 1.5). This continues a long-standing tradition in Italy: indeed, despite common misperceptions about Italy being a reckless spender, the country has been running a significant primary surplus for the past two decades – making it the most ‘virtuous’ country, by mainstream standards, in the entire developed world (and accounting, to a large degree, for Italy’s decades-long stagnation).

The cost of economic ‘virtue’

In this sense, as Ashoka Mody, former assistant director of the International Monetary Fund’s European Department, writes, the European Commission’s insistence that the Italian government continue on the road of austerity ‘is completely unreasonable’. Especially if we consider that Italy’s economy continues to be mired in stagnation or worse. Since the financial crisis of 2007-9, Italy’s GDP has shrunk by a massive 6 per cent, regressing to levels last seen over a decade ago, with no recovery in sight: indeed, the most recent Eurostat GDP data shows near-zero growth for Italy. In terms of per capita GDP, the situation is even more shocking: according to this measure, Italy has regressed back to levels of twenty years ago, before the country became a founding member of the single currency. Italy and Greece are the only industrialised countries that have yet to see economic activity surpass pre–financial crisis levels.

As a result, around 20 per cent of Italy’s industrial capacity has been destroyed, and 30 per cent of the country’s firms have defaulted. Around 10 per cent of Italy’s labour force – and a shocking 31 per cent of its youth – are out of work. If we include underemployed and discouraged workers (people who have given up looking for a job and therefore don’t even figure in official statistics), we arrive at a staggering effective unemployment rate of 30 per cent, which is the highest in all of Europe. Poverty has also risen dramatically in recent years, with about one Italian in four now at risk of poverty – the highest level since 1989.

In short, as economist Bill Mitchell writes, Italy is stuck in a dystopia of ‘low growth, persistently high unemployment, sluggish wages growth, increased poverty rates, and increasing social instability’. This is largely a result of the highly contractionary EU-imposed fiscal policy pursued over the past decade. In view of the above, economic common sense counsels that a robust fiscal expansion – which, as mentioned, not even the government’s original budget provided for – is precisely what Italy needs. Indeed, considering that over 70 per cent of Italy’s GDP is accounted for by internal demand and that the rest of the eurozone is also experiencing a generalised slowdown, it is folly to think that Italy can rely on exports to restore acceptable levels of growth and employment.

The surreal world of EU fiscal rules

Hence, how should we explain the Commission’s ‘ridiculously ferocious attack on Italy’s mildly supportive fiscal policies’, in the words of Michael Ivanovitch, former senior economist at the OECD? One possible explanation is that the Commission is simply trying to uphold the rules-based budgetary order of the eurozone. As unlikely as this is, for reasons that we will see, it is worth going along with this argument for a moment, as it allows us to delve into the surreal world of EU fiscal rules.

Now, an outside observer might wonder what all the fuss was about, considering that a 2.4 per cent deficit is well below the 3 per cent ceiling set by the Maastricht Treaty. The answer lies in the fact that in recent years the EU has changed the way it assesses member states’ budgets: instead of looking at the actual budget deficit, it now takes into account the so-called ‘structural budget balance’ – that is, what the budget deficit would be in the absence of the so-called cyclical component of the budget (that is, the tendency of social expenditure to rise in economic downturns).

At first glance, this might appear like a sensible rule, designed to offer greater fiscal flexibility to economies that are struggling, such as Italy. In the hands of Brussels’ technocrats, however, it yields the exact opposite result. That is due to the way in which the European Commission calculates the cyclical component of the deficit, which in turn is based on the so-called ‘output gap’ – the difference between actual GDP and potential GDP, which is an estimate of the maximum output an economy could achieve at full employment and full capital utilisation without generating inflationary pressures. The higher the negative output gap, the higher the cyclical component of GDP, which could be eliminated through demand- and growth-boosting expansionary fiscal policies. The problem – notes Marcello Minenna, head of quantitative analysis at CONSOB, the Italian Companies and Exchange Commission – is that ‘Brussels’ estimates [of the output gap] make little sense’ and rest entirely ‘on guesswork’ and ‘dubious econometric models’.

In fact, the Commissions predicts a positive output gap of 0.5 per cent for 2019, meaning that Brussels believes that Italy will exceed its maximum ‘non-inflationary potential’ next year, despite an unemployment level of over 10 per cent and near-zero growth. Therefore, the government must slash the deficit now to avoid Italy’s depressed economy from… overheating. That is because of the way in which the Commission calculates a country’s so-called ‘non-inflationary rate of unemployment’: in short, regardless of how high the level of unemployment in a country is, the Commission considers that to the be close to the lowest possible level of unemployment, since the latter is considered to be solely due to ‘structural’ factors, and largely independent from other variables, such as demand, which could be altered through fiscal policy.

Arbitrary enforcement and realpolitik

As the US economist Matthew C. Klein writes, this is patently ‘nonsensical’. Ultimately, however, these technical debates only serve to obfuscate the arbitrary and political nature of the Commission’s decisions. ‘The obscure formulas and shaky models lend themselves to just that: justifying what is decided behind closed doors’, says economist Orsola Costantini. Any doubt that the Commission is acting in bad faith here is dispelled by its very different treatment of countries that have much larger deficits than Italy – most notably France and Spain. France has recently announced a temporary deficit increase to over 3 per cent to respond to widespread protests in the country, while Spain’s deficit this year is now expected to hit 2.7 per cent. Furthermore, both countries have been running primary budget deficits for the past decade – the main factor accounting for their better economic performance vis-à-vis Italy’s. Moreover, the Commission has been silent on Germany’s ongoing and massive current account surplus, which reached 8.4 per cent of GDP in 2017 – well above the 6 per cent threshold allowed under the eurozone’s Macroeconomic Imbalances Procedure – and is widely considered to be one of the main sources of Europe’s deep structural disequilibria.

One may argue that the arbitrary enforcement of the eurozone’s rule could be seen as a weakening of European capitalism’s disciplinary logic, which in turn may open up opportunities for progressive governments – including a British Labour government – to engage in strategic disobedience towards the treaties. Reality, however, is rather different. Firstly, there is nothing new about such arbitrariness. EU rules have always been applied in a selective manner, contingent upon the political clout of the transgressor and other considerations: it’s a well-known fact, for example, that France and Germany both flouted Maastricht’s fiscal rules in the early 2000s, without incurring any consequence whatsoever.

By the same token, deficit fines have not been imposed on Spain or Portugal in recent years despite their breach of the Fiscal Compact rules, presumably for reasons of realpolitik, so as not to bolster the electoral prospects of radical left parties in Iberia. As Andy Storey of the University College Dublin writes, the European institution’s unyielding rules-based rhetoric ‘conceals a consistent willingness on the part of powerful forces in Europe to bend the rules and defy the treaties when it is in the interests of certain actors (including themselves) for them to do so’. But such flexibility doesn’t apply to everyone, as the case of Italy – and even more flagrantly, of Greece – shows. The European institutions will come down hard on any government that is a perceived as a threat to the status quo – let there be no doubt about that.

It has been suggested that the EU’s leniency towards France and Spain has to do with the fact that they have a lower public debt: around 100 per cent of GDP compared to Italy’s 130 per cent. As noted above, it would be a mistake to look for a technical rationale behind the Commission’s evaluations. However, it is worth taking this claim to task, because it sheds light on the perverse dynamics of public debt within the monetary union.

A first point to note is that, even assuming that Italy’s priority should be to reduce its public debt, austerity is not the way to achieve that. Indeed, it is now widely recognised, even by mainstream economists, that fiscal consolidation, due to its recessionary effect on GDP, ‘can have persistent “perverse” effects on the debt-to-GDP ratio – especially when the economy is in a recession and fiscal multipliers are particularly high’. Italy is a great case in point, having seen its debt-to-GDP ratio balloon by 15 percentage points since 2011 – that is, since successive governments started implementing harsh austerity measures. As acknowledged even by Jim O’Neill, a former chairman of Goldman Sachs Asset Management and former UK Treasury minister, the only way for Italy to stabilise its public debt is through ‘stronger nominal GDP growth – plain and simple’.

It was also suggested that what little expansionary effect could be expected from the new government’s budget was – and is – likely to be wiped out by the increase in the interest rates on Italy’s public debt and thus on its overall interest expenditure. While this may be technically true, it would be a mistake to consider such an increase in interest rates as a function of the package itself; it should instead be seen as a consequence of the flawed architecture of the eurozone – which in turn has been compounded by the European institution’s reaction to the budget. Simply put, in a country that issues its own currency, the notion that an increase in the deficit- or debt-to-GDP ratio inevitably entails rising interest rates is a fallacy. That is because the central bank, as a buyer of last resort, ultimately sets the interest rate.

In the eurozone, on the other hand, the ECB also intervenes on the sovereign bond markets of member states through its quantitative easing program but it does so on the basis of fixed quotas; it cannot boost its acquisitions of bonds for a specific country to quell market speculation. Or better, it can only do so through its Outright Monetary Transactions (OMT) programme, which entails ‘strict and effective conditionality’ such as the one imposed on Greece and other countries – i.e., austerity and neoliberal structural reforms – explaining why no country has yet applied for an OMT programme. This would be politically unsustainable, for obvious reasons. However, as the Italian case shows, not only is the ECB unable to protect countries from rising interest rates, but more often than not the European institutions actively (and, one must presume, deliberately) contribute to exacerbating market tensions, as the harsh pronouncements by Jean-Claude Juncker, Pierre Moscovici and others did in the recent standoff.

Ultimately, this story illustrates not only the seemingly irrational but deeply political nature of Europe’s fiscal rules (and of its overall architecture) but also the fundamental incompatibility between democracy and the euro, which is leading inexorably towards its collapse regardless of the outcome of Brexit. It is imperative that the European left starts to come to terms with these realities.

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