The devil is in the detail of Rome’s new budget

  • October 19, 2018

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Italy’s budget plans for 2019 have been panned all round, including by investors who are now demanding a yet higher premium to lend to the government. Rome has now sent the formal draft budget to Brussels, giving both the European Commission and the rest of us concrete numbers to assess (and making markets a tad calmer).

The biggest danger around this budget is that it leads to a damaging political fight between Italy’s populist government and its eurozone counterparts and the commission. That will depend on choices taken over the next weeks and months. (Bruegel’s Grégory Claeys and Antoine Collin set out the commission’s various options.) Meanwhile, how should we think about it in economic terms?

The short answer is that the microeconomic aspects of the budget are worse than the macroeconomics. Most critics have berated the government for expanding, rather than shrinking, the deficit: Rome now projects net borrowing rising to 2.4 per cent of gross domestic product next year, instead of falling to the 0.8 per cent planned by the previous government. Public debt is certainly high, but the budgetary cost of servicing it is the lowest in almost 40 years, as the chart below shows. What matters most for sustainability is the effect on growth.

The key to our judgment on the macroeconomic impact on the budget must be whether we think the Italian economy is at full employment or not. While many observers seem to think this is the case, that is hard to believe when unemployment, though falling, remains more than 4 percentage points above the pre-crisis low. If there remains unused potential, extra stimulus to demand should feed through to short-term growth. For an economy as stagnant as that of Italy, a short-term growth boost is not to be scoffed at.

And on the assumption of less than full employment, the government’s bold projections are not so unreasonable. For a deficit 1.6 percentage points bigger than previously planned, it foresees a boost to growth of 0.6 percentage points, or a litte more than one-third of the deficit change. That is a very conservative take on the fiscal “multiplier effect” of government deficit spending on aggregate demand, especially in a currency union where monetary policy will not move to offset a single country’s fiscal stimulus. If the multiplier is this size, let alone bigger, Rome’s insistence that it can contain public finances through growth-friendly budget policy deserves a hearing. If the commission finds that it goes against EU fiscal rules, that says as much about the rules as about the budget.

There are nevertheless good reasons to be sceptical, but these are more microeconomic than about the overall fiscal stance. First, the market reaction matters if the budget prompts investors to make financing costlier. This is a real risk, especially because the government’s commitments to deficit-cutting beyond next year are hard to trust. The government’s own cost of borrowing is only slowly phased in as Rome issues new bonds to fund the redemption of maturing ones. But a higher bond spread could also directly affect private borrowing costs. If investors demand more to finance Italian banks — and they have been since the government took office — that cost will, at least in part, be passed on to the banks’ business and household clients. (On the other hand, much of Italian financing is domestic, so higher rates put more money in the hands of savers.) All this could make the fiscal multiplier smaller, with private retrenchment offsetting the government’s demand stimulus.

But the deeper worries concern not how much Rome wants to spend, but on what. I have been more sympathetic to the government’s priorities than many others, but there is much not to like in this budget. As my former colleague Ferdinando Giugliano puts it, it “looks like a ‘Greatest Hits’ album containing all the measures that have failed to spur growth in the past”. Indeed, Rome has a sorry record of using its budget to create long-term supply-side growth. Alessio Terzi at Bruegel shows that Italian public investment, for instance, is unusually poor at lifting economic output in the long term.

In this case, the tax and spending changes in the government’s budget do not target what is likely to promote growth. It does not reduce the high tax “wedge” between company labour costs and take-home pay that is one of the biggest hindrances to greater hiring. It has not made permanent contracts more flexible in order to encourage long-term hiring à la Macron. The budget reverses an increase in the retirement age.

None of this is catastrophic. But if the populists in Rome were going to pick a fight with Brussels over macroeconomics, they could at least have used it as an opportunity to get the microeconomics right in the process.

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