Taxing the super-rich to save capitalism from itself

[Usual Caveat: AI Generated translation (with slight edits) of a piece written in Italian]

The distribution of income has become topical again in recent days, and it is likely going to be one of the issues that will characterize the debate on the global governance of the economy in the coming months.

First, U.S. President Joe Biden announced a plan to reduce public debt centered on raising the minimum corporate tax from 15% to 21%, and on a minimum income tax of 25% for billionaires. The announcement is especially significant because it was made in the traditional State of the Union address, a solemn moment that this year also marks the beginning of the election campaign for the November elections. It is no coincidence that Biden has decided to call on the super-rich and corporations, especially the largest, to contribute the most to public finances’ healing: they are in fact the two categories that have managed to offload most of the inflation of recent years on consumers, wages and the less well-off categories in general.

The plan is highly unlikely to become a reality in a Congress dominated by a radicalized Republican Party, united behind Donald Trump, and conservative Democrats. But its symbolic significance is important and makes it clear what interests the president intends to defend in the November elections. With this proposal, the Biden administration proves once again, at least as far as economic issues are concerned, to be the most progressive in recent decades, much more courageous in attempting to protect the middle classes than the iconic, but ultimately too timid, Barack Obama.

A minimum tax rate for the super-rich

The issue of tax justice, and this is the second piece of recent news, is also at the center of the agenda of Lula’s Brazilian government, which in 2024 holds the rotating presidency of the G20. The G20 is probably the most significant body today for the coordination of economic policies at the international level. It is therefore particularly significant that the idea of reintroducing more progressivity by taxing the super-rich, which is not new in itself, is being discussed there.

In front of the G20 finance ministers that were meeting in São Paulo, the Berkeley economist Gabriel Zucman pleaded for  a fairer global system, first of all insisting on how tax progressivity, being crucial for financing public goods such as health, education, infrastructure, is one of the pillars on which the growth and the social contract of well-functioning democracies are based. Second, documenting how the tax systems of most countries have, in recent decades, become fundamentally regressive, especially with regard to the few thousand super-rich that sit at the top of the income distribution. In France, for example, the poorest 10% of the population pays almost 50% of their income in taxes, while the super-rich pay less than a third (the figure is taken from the 2024 Global Tax Evasion Report).

The reasons for this aberration are well known: the unbridled rush of recent decades to fiscal dumping, the benefits offered by many countries to multinationals and higher income owners in an attempt to attract them, have created a multitude of tax niches and possibilities for the wealthier to structure their income and their fortune in such a way as to generate low or no taxable incomes.

Precisely to avoid fiscal competition between countries, which allows the wealthier (but also multinationals) to travel in search of tax havens, Zucman and others are pushing for a global solution, along the lines of the BEPS agreement reached at the OECD in 2021 on the taxation of multinationals. For this reason, the initiative of the Brazilian presidency and the decision of the G20 finance ministers to commission a report that goes into the details of the proposal are very good signs.

Beyond the details that will need to be worked on, crucial to avoid loopholes and avoidance, the proposal by Zucman the economists of the Tax Observatory he heads, on which the G20 will discuss in the coming months, is that of a minimum rate of taxation on the super-rich, designed taking as a model the aforementioned OECD agreement on the minimum rate for multinationals. Since income, for the reasons mentioned above, is very difficult to compute, the international community should agree that taxpayers pay at least a certain percentage of their wealth in income taxes (Zucman proposes 2%). The proposal has several advantages: (1) those who already pay high income taxes would not have any additional burden, while those with large wealth that manage to hide their income from the tax authorities (in a more or less legal way) would be called upon to pay. (2) in many countries there are already instruments for assessing wealth, which would therefore only need to be generalised and harmonised. (3) as with the minimum tax on multinationals, mechanisms can be devised to discourage the relocation of wealth to countries that decide not to cooperate. (4) even with just a low rate like the one proposed by Zucman, it would be possible to obtain tax revenues of hundreds of billions a year, which are needed above all by the poorest countries to finance welfare, ecological transition, and infrastructure for growth.

Last, but certainly not least, being able to get the richest to contribute to the common good would help at least in part to restore the sense of justice and trust in the social contract that has progressively eroded in recent decades. As Zucman concludes in his address to the G20 ministers, “Such an agreement would be in the interest of all economic actors, even the taxpayers involved. Because what is at stake is not only the dynamic of global inequality: it is the very social sustainability of globalization, from which the wealthy benefit so much.”

The conservative revolutions of the early 1980s ushered in an era in which the watchword was simply “get as rich as you can and think only of yourself” (exemplified by Gordon Gekko’s praise of greed in Oliver Stone’s masterful Wall Street). That era did not bring us the promised prosperity or stability. On the contrary, we now live in sick democracies, unstable economies characterized by intolerable levels of rent seeking and inequality. In the 1930s, one of Keynes’s goals in pleading for an active role of the government was to save capitalism, in crisis and threatened by the rise of the Soviet Union. The many who are in love with the supposed Great Moderation of the 1980s and 1990s stubbornly opposing all attempts to correct excessive inequality, should think twice. Instead, they should endorse wholeheartedly attempts such as that of the G20 Brazilian presidency to save capitalism above all from its internal enemies, far more dangerous than the external ones.

Austerity. The Past That Doesn’t Pass

[As usual lately, this is a slightly edited AI translation of a piece written for the Italian Daily Domani]

The European Commission recently revised downwards its forecasts for both growth and inflation, which continues to fall faster than expected. In contrast to the United States, there is no “soft landing” here. As argued by many, monetary tightening has not played a major role in bringing inflation under control (even as of today, price dynamics are mainly determined by energy and transportation costs). Instead, according to what the literature tells us on the subject, it is starting, 18 months after the beginning of the rate hike cycle, to bite on the cost of credit, therefore on consumption, investment and growth.

This slowdown in the economy is taking place in a different context from that of the pandemic. Back then, central bankers and finance ministers all agreed that business should be supported by any means, a fiscal “whatever it takes”. Today, the climate is very different, and public discourse is dominated by an obsession with reducing public debt, as evidenced by the recent positions taken by German Finance Minister Lindner and the disappointing reform of the Stability Pact. The risk for Europe of repeating the mistakes of the past, in particular the calamitous austerity season of 2010-2014, is therefore particularly high.

In this context, we can only look with concern at what is happening in France, where the government also announced a downward revision of the growth forecast for 2024, from 1.4% to 1%. At the same time, the Finance Minister Bruno Le Maire announced a cut in public spending of ten billion euros (about 0.4% of GDP), to maintain the previously announced deficit and debt targets. This choice is wicked for at least two reasons. The first is that it the government plans making the correction exclusively by cutting public expenditure, focusing in particular on “spending for the future”. €2 billion will be taken from the budget for the ecological transition, €1.1 billion for work and employment, €900 million for research and higher education, and so on. In short, it has been chosen, once again, not to increase taxes on the wealthier classes but to cut investment in future capital (tangible or intangible).

But regardless of the composition, the choice to pursue public finance objectives by reducing spending at a time when the economy slows, down goes against what economic theory teaches us; even more problematic, for a political class at the helm of a large economy, it goes against recent lessons from European history.

The ratio of public debt to GDP is usually taken an indicator (actually, a very imperfect one, but we can overlook this here) of the sustainability of public finances. When the denominator of the ration, GDP, falls or grows less than expected, it would seem at first glance logical to bring the ratio back to the desired value by reducing the debt that is in the numerator, i.e. by raising taxes or reducing government spending. But things are not so simple, because in fact the two variables, GDP and debt, are linked to each other. The reduction of government expenditure or the increase of taxes, and the ensuing reduction of the disposable income for households and businesses, will negatively affect aggregate demand for goods and services and therefore growth. Let’s leave aside here a rather outlandish theory, which nevertheless periodically re-emerges, according to which austerity could be “expansionary” if the reduction in public spending triggers the expectation of future reductions in the tax burden, thus pushing up private consumption and investment. The data do not support this fairy tale: guess what? Austerity turns out to be contractionary!

In short, a decline in the nominator, the debt, brings with it a decline in the denominator, GDP. Whether the ratio between the two decreases or increases, therefore, ends up depending on how much the former influences the latter, what economists call the multiplier. If austerity has a limited impact on growth, then debt reduction will be greater than GDP reduction and the ratio will shrink: albeit at the price of an economic slowdown, austerity can bring public finances back under control. The recovery plans imposed by the troika on the Eurozone countries in the early 2010s were based on this assumption and all international institutions projected a limited impact of austerity on growth. History has shown that this assumption was wrong and that the multiplier is very high, especially during a recession. A  public mea culpa from  the International Monetary Fund caused a sensation at the time (economists are not known for admitting mistakes!), explaining how a correct calculation gave multipliers up to four times higher than previously believed. In the name of discipline, fiscal policy in those years was pro-cyclical, holding back the economy when it should have pushed it forward. The many assistance packages conditioning the troika support to fiscal consolidation did not secure public finances; on the contrary, by plunging those countries into recession, they made them more fragile. Not only was austerity not expansive, but it was self-defeating. It is no coincidence that, in those years, speculative attacks against countries that adopted austerity multiplied and that, had it not been for the intervention of the ECB, with Draghi’s whatever it takes in 2012, Italy and Spain would have had to default and the euro would probably not have survived.

Since then, empirical work has multiplied, with very interesting results. For example, multipliers are higher for public investment (especially for green investment) and social expenditure has an important impact on long-term growth. And these are precisely the items of expenditure most cut by the French government in reaction to deteriorating economic conditions.

While President Roosevelt in 1937 prematurely sought to reduce the government deficit by plunging the American economy into recession, John Maynard Keynes famously stated that “the boom, not the recession, is the right time for austerity.” The eurozone crisis was a colossal and very painful (Greece has not yet recovered to 2008 GDP levels), a natural experiment that proved Keynes right.

Bruno Le Maire and the many standard-bearers of fiscal discipline can perhaps be forgiven for their ignorance of the academic literature on multipliers in good and bad times. Perhaps they can also be forgiven for their lack of knowledge of economic history and of the debates that inflamed the twentieth century. But the compulsion to repeat mistakes that only ten years ago triggered a financial crisis, and threatened to derail the single currency, is unforgivable even for a political class without culture and without memory.

Fiscal rules: a return to the past that condemns Europe to irrelevance.

[As usual lately, this is an English AI translation of a piece written in Italian, updated to take into account yesterday’s European Parliament vote]

After three years of near-inaction, and a few months of frantic negotiations, European finance ministers have finally reached an agreement on the reform of the Stability and Growth Pact., that is now being discussed with the European Parliament. At first glance one might think, looking at the ballet of percentages, safeguard clauses, classifications, that this is a technical issue, for insiders. Nothing could be further from the truth. What was at stake, in the discussion that ended with the December last-minute agreement, was the framework within which European countries will have to operate in the coming years to face the challenges that await them. Few things are more relevant today. And that’s why it was a bad agreement. A return to the past that condemns the already battered Europe to irrelevance.

The old Pact now relegated to the attic faced widespread criticism: for its baroque complexity and reliance on numerous, at times arbitrary indicators; for its emphasis on one-size-fits-all yearly limits, fostering short-term discipline that, in effect often turned pro cyclical; for its bias against public investment. Most importantly, the old Pact was consistent with a worldview where the state’s role in the economy had to be limited among other things by imposing restrictive rules on fiscal policies.

That world no longer exists, and this explains the opening, in 2020, of the reform process of the Stability Pact. The 2008 Global Financial Crisis, the calamitous management of the euro crisis, the pandemic and finally inflation, have shown that there can be no stability and growth without stabilisation policies, without adequate levels of public goods such as health and education, without industrial policies and public investment for the ecological and digital transitions. In short, without an active role of the state in the economy.

For this reason, the discussion among academics and policy makers (largely ignored by governments, which woke up at the last minute) centered around the necessity for a philosophical shift. The new rule, it was widely believed, had to change this and put the protection of fiscal space for public policies a the centre of the stage (ensuring, of course sustainability of public finances). A change in philosophy that was to be found in the reform proposal put forward in 2022 by the European Commission. Albeit imperfect, the proposal abandoned the one-size-fits-all annual targets in favor of medium-term plans designed by countries in agreement with the Commission, in a framework that would guarantee debt sustainability and try to achieve an (excessively) moderate protection of public investment.

That framework is still there, but it has been transformed in an empty shell. On paper, multi-annual plans and investment protection still exist. But Germany, reverting to its old obsession with austerity, has imposed a plethora of complex (and as baroque as those of the old Pact) safeguard clauses that will be triggered in the event of excessive debt or deficits (i.e., almost always for almost everyone) and which, overruling the plans agreed with the Commission, go back to imposing one-size-fits-all annual numerical constraints, sometimes even more restrictive than the old rule. Like in the widely criticized old Stability Pact, debt reduction is still the alpha and omega, and it is no coincidence that all frugal countries rejoice that the new rule will be more effective in forcing fiscal discipline than the old one.

The Italian and French governments, the only ones that could have turned the board over, settled for a bare minimum, some short-term flexibility, in order to arrive at their respective elections with some money to spend. A short-sighted and depressing strategy: the elections, and these governments, will pass, but the rule will remain and tie our hands, while China and the United States make colossal investments in the future. It’s all right, as long that those celebrating victory today do not to come and tear their clothes in a few years’ time, when Europe will have become even more irrelevant than it is today.

Wolfgang Schäuble’s Ideas are Alive and Kicking

[As usual lately, this is an English AI translation of a piece written for the Italian Daily Domani]

Wolfgang Schäuble was a central figure in the German political landscape. A member of parliament for the centre-right Christian Democrats party from 1972 until his death on Tuesday evening at the age of 81, he was very close to Chancellor Helmut Kohl and, as a lawyer, one of the negotiators of the treaty that brought about the reunification with East Germany. But it was with Angela Merkel as Chancellor that Schäuble became known beyond national borders. For a few years Minister of the Interior, he was appointed Minister of Finance in 2009, a few weeks before the revelations about the state of Greek public finances that triggered the sovereign debt crisis. Since then, he has been one of the central figures in the calamitous management of the crisis. A staunch pro-European, he has nevertheless always been convinced, in homage to the ordoliberal doctrine, that integration could only be achieved by harnessing the European economy in a dense network of rules that would guarantee the public and private thrift necessary to make the EU competitive on world markets. Schäuble was the main standard-bearer of the “Berlin View” (or Brussels or Frankfurt, being adopted by the heads of the European Commission and the ECB of the time) which attributed the debt crisis to the fiscal profligacy and lack of reforms of the so-called “peripheral” EMU countries. A narrative about the crisis that forced “homework” (austerity and structural reforms) on the countries in crisis: we owe to Schäuble’s intransigence, backed by Angela Merkel, the Commission and the ECB (and sometimes against the IMF, which often had a more pragmatic approach), the draconian conditions imposed on Greek governments in exchange for financial assistance from the so-called Troika. In those years, he and the then president of the ECB, Jean-Claude Trichet, argued, against all empirical evidence, for expansionary austerity, the idea that fiscal restriction would supposedly free markets’ animal spirits and thus revive growth. An austerity that Schäuble imposed on countries in crisis but also followed at home. On the occasion of his departure from the Ministry of Finance in 2017, the photo of the employees forming a large zero in the courtyard in homage to the achievement of a balanced budget objective went around the world.

History has taken it upon itself to show the ineffectiveness and cost of that strategy. Not surprisingly, austerity is almost never expansionary and certainly has not been so in the eurozone. The fiscal adjustment imposed on the EMU peripheral countries triggered a crisis which for some of them had not yet been absorbed by the end of the decade.  A crisis that, moreover, could have been less painful if the countries in better shape had supported the eurozone growth with expansionary policies, instead of adopting a restrictive stance themselves. The EMU is the only large advanced economy that suffered a second recession in 2012-13, after the Global Financial crisis of 2008. Not only that: since then, domestic demand has remained anaemic, and the European economy has become “Germanized”, managing to grow only thanks to exports; this contributes to the growing trade tensions, and Germany stands accused by international bodies and by the United States of exerting deflationary pressure on the world economy.

The narrative of a crisis caused by the fiscal irresponsibility of spendthrift governments quickly lost its luster and already in 2014 many of its initial supporters (e.g. Mario Draghi, who in the meantime became president of the ECB) opted for a more “symmetrical” explanation, according to which the trigger of the crisis were balance of payments imbalances of which the over-spendthrift and the over-austere countries were equally guilty. But Schäuble never backed from his belief that the only necessary medicine was the downsizing of public spending; Germany also imposed this view to its partner when reforming the European institutions (from the ESM to the fiscal compact).

With the Covid crisis and Germany’s staunch support for Next Generation EU, it seemed that the ordoliberal doctrine finally went into retirement, along with Schäuble, its proudest partisan. But recent events show us that this was wishful thinking. Schäuble would probably have approved the (non-)reform of the Stability Pact imposed by his successor Lindner, whose only guiding light is the reduction of public debt. Schäuble has left us, but the fetish of public and private thrift as a healing virtue is alive and well.

Wages and Inflation: Let Workers Alone

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

Last week’s piece of news is the gap that opened between the US central bank, the Fed, and the European and British central banks. Apparently, the three institutions have adopted the same strategy, deciding to leave interest rates unchanged, in the face of falling inflation and a slowdown in the economy. But, for central banks, what you say is just as important as what you do; and while the Fed has announced that in the coming months (barring surprises, of course) it will begin to loosen the reins, reducing its interest rate, the Bank of England and the ECB have refused to announce cuts anytime soon.

To understand why the ECB remains hawkish, one can read  the interview with  the Financial Times  of the governor of the Central Bank of Belgium, Pierre Wunsch, one of the hardliners within the ECB Council. Wunsch argues that, while inflation data is good (it is also worth noting that, as many have been saying for months, inflation continues to fall faster than forecasters expect), wage dynamics are a cause for concern. In the Eurozone, in fact, these rose by 5.3% in the third quarter of 2023, the highest pace in the last ten years. The Belgian Governor mentions the risk that this increase in wages will weigh on the costs of companies, inducing them to raise prices and triggering further wage demands; As long as wage growth is not under control, Wunsch concludes, the brakes must be kept on. Once again, the restrictive stance is justified by the risk of a price-wage spiral, that so far never materialized, despite having been evoked by the partisans of rate increases since 2021. Those who, like Wunsch, fear the wage-price spiral, cite the experience of the 1970s, when the wage surge had effectively fueled progressively out-of-control inflation. The comparison seems apt at first glance, given that in both cases it was an external shock (energy) that triggered the price increase. But, in fact, it was not necessary to wait for inflation to fall to understand that the risk of a wage-price spiral was overestimated and used by many as an instrument. Compared to the 1970s, in fact, many things have changed. I talk about this in detail  in Oltre le Banche Centrali, recently published by Luiss University Press (in Italian): Automatic indexation mechanisms have been abolished, the bargaining power of trade unions has greatly diminished and, in general, the precarization of work has reduced the ability of workers to carry out their demands. For these and other reasons, the correlation between prices and wages has been greatly reduced over three decades.

But the 1970s are actually the exception, not the norm. A recent study by researchers at the International Monetary Fund looks at historical experience and shows that, in the past, inflationary flare-ups have generally been followed with a delay by wages. These tend to change more slowly than prices, so that an increase in inflation is not followed by an immediate adjustment in wages and initially there is a reduction in the real wage (the wage adjusted for the cost of living). When, in the medium term, wages finally catch up with prices, the real wage returns to the equilibrium level, aligned with productivity growth. If the same thing were to happen at this juncture, the IMF researchers believe, we should not only expect, but actually hope for nominal wage growth to continue to be strong for some time in the future, now that inflation has returned to reasonable levels: looking at the data published by Eurostat, we observe that for the eurozone, prices increased by 18.5% from the third quarter of 2020 to the third quarter of 2023,  while wage growth stopped at 10.5%. Real wages, therefore, the measure of purchasing power, fell by 8.2%. Italy stands out: it has seen a similar evolution of prices (+18.9%), but an almost stagnation of wages (+5.8%), with the result that purchasing power has collapsed by 13%.

Things are worse than these numbers show. First, for convergence to be considered accomplished, real wages will have to increase beyond the 2021 levels. In countries where productivity has grown in recent years, the new equilibrium level of real wages will be higher. Second, even when wages have realigned with productivity growth, there will remain a gap to fill. During the current transition period, when real wages are below the equilibrium level, workers are enduring a loss of income that will not be compensated for (unless the real wage grows more than productivity for some time). From this point of view, therefore, it is important not only that the gap between prices and wages is closed, but that this happens as quickly as possible.

In short, contrary to what many (more or less in good faith) claim, the fact that at the moment wages are growing more than prices is not the beginning of a dangerous wage-price spiral and the indicator of a return of inflation; rather, it is the foreseeable second phase of a process of rebalancing that, as the IMF researchers point out, is not only normal but also necessary.

The conclusion deserves to be emphasized as clearly as possible: if the ECB or national governments tried to limit wage growth with restrictive policies, they would not only act against the interests of those who paid the highest price for the inflationary shock. But, in a self-defeating way, they would prevent the adjustment from being completed and delay putting once and for all the inflationary shock behind us.

Markets are also rooting for a European Central Fiscal Capacity

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

An interesting article published a few days ago in  the Financial Times highlights one of the many paradoxes that the European Union is facing. The article is apparently technical and aimed at insiders, but in reality, it highlights a political problem for Europe, a global player that stubbornly does not equip itself with the tools to fully play its role. The authors note that for the first time in its history, mainly because of the Next Generation EU  programme, the European Union is now issuing a debt of significant size, which will reach €900 billion in 2026 (in 2020 it was just €50 billion). This is happening for the first time, as we said, because one of the pillars of the European Union budget is the principle of equilibrium: unlike the Member States, under normal conditions the EU must have a balanced budget. The issuance of debt by the Union, therefore, must always pass “off-balance-sheet”, through financial vehicles set up for specific and exceptional purposes. Until the pandemic, and the creation of Next Generation EU, this had been done for negligible amounts, and there was little debt properly European circulating on the markets.

The debt linked to Next Generation EU  was initially plebiscited by markets, which fought over the first issuances at zero or negative rates; but, notes  the Financial Times, European debt is today less desirable than that of some member countries: the ten-year interest rates of the EU, a debtor with the highest rating (AAA) are higher than those of Germany,  but also to those of France, which has a lower rating (AA). Why are markets more inclined to buy bonds from a relatively riskier debtor like France than those issued by the European Union? The explanation lies in the oft-forgotten fact that liquidity, i.e., the ease with which a security can be traded, also contributes along with risk to determining the attractiveness of financial investment. And a security is liquid, easily exchangeable, if at any given moment there are buyers for those who want to sell, and sellers for those who want to buy. This is precisely the problem with European debt today: of course, today the amount of bonds issued is significant, especially when compared to a few years ago. But what guarantees the markets that debt issuance will continue even after 2026, when the last Next Generation EU bonds will be put on the market? In other words, once this phase is over, will there continue to be a market for European stocks?

In short, investors are skeptical (unfortunately rightly so) and are unable to understand  whether the Next Generation EU  program is an isolated measure, the result of the Covid emergency, or whether it can become a sort of model to finance the colossal investment programs necessary for the ecological and digital transitions in the future. In short, the markets are trying to figure out whether in the more or less near future a European fiscal capacity could materialize: an agency that, acting as a sort of EU finance minister, would be capable of finding resources to finance EU expenditure, including by issuing European debt.

The discussion on reforming the EU fiscal rule is peaking. Just a few days ago, the Eurozone finance ministers reaffirmed their intention to quickly approve a rule that would replace the outdated and no longer credible Stability Pact. As argued here, in order to be approved quickly, the reform will probably, and unfortunately, be a minimalist compromise. It is likely that the new Stability Pact will not be too different from the old one and that it will not allow governments to adequately finance public goods, industrial policies, and public investment.

If this is the case, there is an urgent need to put the creation of a central fiscal capacity back at the centre of the debate on the European institutional set-up. The issue has always been present under the radar but is struggling to impose itself on the agenda of European reforms. It can be argued convincingly (as the former head of Commissioner Gentiloni’s cabinet, Marco Buti, does in an article written with Marcello Messori) that the creation of a central fiscal capacity would make it possible to provide for economic stabilisation and to finance European public goods more effectively and at lower cost than through national policies. It would also make it easier and more stable to finance transnational investment projects, again with an efficiency gain compared to the Next Generation model, which seeks to achieve coherence between national plans (the NRRPs) through conditions on the destination of funds.

 The (modest) difficulties in placing European debt issues add an additional reason for the creation of a central fiscal capacity. Not only would it have obvious macroeconomic and structural benefits, but it would also help stabilise financial markets. Firstly, because, as mentioned above, it would help to provide markets with a stable supply of a safe, liquid and attractive asset, reducing financing costs for the EU. Secondly, because the European financing of part of public policies would make it possible to lighten the burden on the shoulders of member countries, which could more easily keep their debt under control. The segmentation of European financial markets would thus be reduced, and the cost of debt would fall for everyone. Thirdly, the existence of European debt would allow the ECB to sell and buy securities to regulate the liquidity of the system without having to scramble to hold the bonds of different countries in proportion to their economic weight. Finally, because the existence of a European debt would make it possible to consolidate the role of the euro as one of the international reserve currencies, once again ensuring stability and sustainability.

Unfortunately, as we said, the creation of a centralised fiscal capacity is not a priority in today’s EU political agenda. First of all, because it would be necessary to change the Treaties in order to get rid of the principle of equilibrium which, as we said, is now embedded in the European budget. Moreover, the creation of the capacity to spend, tax and borrow centrally, while electoral accountability to the electorate remains at the level of national governments, would require a complex system of checks and balances aimed at ensuring that no further European democratic deficit emerges (which would open up prairies for sovereigntists and Eurosceptics of various backgrounds). It will therefore be difficult to build consensus on such a complex and innovative proposal, among European countries weakened by multiple crises and increasingly looking inwards. In short, it is a complex construction site. But it still needs to be opened as soon as possible.

On the Stability Pact, no hurry. For once, let’s try to be forward looking.

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

This Fall the right-wing Italian government will face a difficult balancing act, with a resource-less budget law and slowing growth. It is then not a surprise that in recent weeks members of the cabinet finally woke up, rediscovering the debate about the reform of European rules. Ministers Giorgetti (Treasury) and Fitto (European Affairs) sounded the alarm about the possible return of the Stability Pact, suspended since 2020.

It is useful to summarize the situation, for those who did not follow the discussion in the past months. With the pandemic, in March 2020, the European Commission immediately activated the Stability and Growth Pact suspension clause to allow European countries to respond to the health and economic crisis with budget policies. The Pact was actually already under heavy criticism, so much so that the Commission had already launched a consultation process on its revision. Some, including myself, had criticized the Pact even during the “great” (and illusory) convergence in the early 2000s. But the flaws became evident with the sovereign debt crisis when the European rules, instead of securing the economy and public finances, had the opposite effect: austerity sunk the economies of so-called peripheral countries (primarily Greece, but also Italy, Portugal, and to a lesser extent Spain) without making their public finances more sustainable. Many economists (including those from the Commission) now agree that in addition to forcing countries to implement pro-cyclical policies (budget restriction in an economic crisis), the existing rules hinder public investment, industrial policies, and inequality reduction. Above all, they turn budget laws into exercises in trimming decimal percentage points of deficits, rather than moments for planning public policies to address the major challenges we face.

The Commission, which had strongly supported austerity policies in the 2010s, deserves praise for the change in perspective that emerged from a working proposal put forward at the end of 2022. Without going into details, that proposal, despite its flaws, abandoned the idea that the sole guiding principle of public policies should be debt reduction and envisioned a rule that would allow each country ample leeway to autonomously design its budget policies over multi-year horizons, as long as the sustainability of public finances was guaranteed.

Unfortunately, despite being silent for a while following the disasters of the 2010s and being forced by the pandemic to accept a more active role for budget policies, the hawks of public finances, the so-called “frugals,” have reemerged at the earliest opportunity. Thus, the German Finance Ministry published a short text last spring that called the Commission to order just a few weeks before it presented a formal legislative proposal. In fact, that proposal, compared to the November 2022 document, marked a return to the guiding principle of debt reduction and annual deficit targets. All this happened in the substantial silence of the Italian, French, and Spanish governments. I cannot recall a single intervention by the leaders of these countries in support of the Commission under attack from frugal countries.

Today something is changing. The idea of a “golden rule” is back, allowing certain investments (ecological transition, digitalization, and defense, to obtain approval from Eastern countries) to be excluded from the deficit calculation. Italy, France, and Spain are struggling to coordinate on this rule in anticipation of the finance ministers’ meeting in the coming weeks. Even the German government, given the growth crisis and the industrial and infrastructural obsolescence plaguing the country, might compromise, especially if it obtained a relaxation of the state aid regulations in return.

Perhaps the hawks have not yet won, and there is room for an improvement of the current fiscal framework. Now the main risk is that, fearing that the old Pact will come back into force on January 1, 2024, we settle for a compromise that lowers the bar. The world is changing quickly, and the risk of Europe becoming economically and geopolitically irrelevant has never been higher. Industrial policies and public investment will be the main leverage to ensure growth and positioning in future sectors. The Chinese and American governments understood this years ago, while we continue to formulate ambitious programs that we do not adequately finance, pulling in all directions a blanket that remains inexorably short.

We cannot be satisfied with some cosmetic adjustments to a framework that remains oriented towards reducing spending and public debt. Given the stakes, the January 1 deadline should be the least of our problems. The new rule will remain in effect for years, and it is better to adopt a good rule late than a bad one on time. It’s so obvious that it seems absurd to have to emphasize it. If a serious and in-depth negotiation could be initiated that goes beyond the fall, the Commission could extend the suspension clause or adopt all the flexibility necessary to prevent the old Pact from biting.

Of course, we have had three years, and it is depressing that on this topic, much more important than many others, we have waited until the last moment to act. The only visible participants in the European debate have been the Commission, which has done its job, and the frugals, led by Germany, who have occupied the field. The Italian and French governments were MIA, and today we are paying the price for this absence. Shortsightedness continues to be the common thread that ties the leadership of European countries.

To Reshore, or not to Reshore, that is the question

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

In June 2023, over three years after the beginning of the pandemic, the Global Container Freight Index, one of the measures of maritime transportation cost, has returned to 2019 levels. At its peak in the summer of 2021, it had nearly increased tenfold. The Global Supply Chain Pressure Index (GSCPI) calculated by the Federal Reserve Bank of New York has also been below historical averages for a few months now. These developments, along with the decline in energy prices (though still with significant variability), indicate that we can now consider the phase of disruption in global production and trade, which began with the pandemic and continued in 2021 and 2022 when the economy restarted, to be closed.

However, having returned (more or less) to normalcy doesn’t mean that we should stop questioning the vulnerabilities highlighted by the crisis. Since 2020, an interesting debate has been ongoing about the strategic autonomy of major economies (such as the European one) that have discovered to be dependent on not always reliable foreign suppliers, and more generally on the complexity and fragility of the globalized economy. This is a complex discourse, where considerations on value chains intertwine with the broader discussion on the costs and benefits of globalization. It’s not surprising, therefore, that reaching clear-cut conclusions is challenging.

Cost minimization cannot be the only guide

Advocates of reshoring, the bringing back some of the production processes previously outsourced to extreme levels, put forth several arguments:

The first is that the outsourcing of production processes has gradually eroded the strategic autonomy of many advanced countries, resulting in detrimental outcomes not only economically but also geopolitically. The struggle for dominance between emerging and advanced economies, along with the risks to public health posed by climate change, make it essential to seriously consider building rapid response capabilities to energy, health, or geopolitical shocks without depending on imports.

Then, the experience of recent years also shows that excessively long value chains indeed minimize costs, but at the cost of great fragility. Consider that in the first quarter of 2020, when only China had gone into lockdown (Italy being the first European country to do so, only shut down its economy on March 9), GDP plummeted nearly everywhere due to difficulties in sourcing for businesses and wholesalers (-6.4% for Italy, -4.7% for Spain, -5.2% for France, -1.2% for Germany, -2.8% for the Eurozone; OECD data). According to reshoring proponents, the almost exclusive emphasis on minimizing production costs could have been justified in a macroeconomic and geopolitical stable context (or at least one that seemed stable) like the one we lived in until the early 2000s. If the world in the coming years will resemble the turbulent one of recent times, it might be worthwhile for countries and businesses to attempt to protect themselves by shortening value chains, even if it leads to higher production costs. It’s interesting to note that this discussion is another manifestation of the crisis of the Consensus that dominated macroeconomics until the early 2000s: It’s evident that if one believes in the market’s capacity to absorb shocks without external aid, neglecting “resilience” to solely focus on production costs is the winning strategy. When faith in the market as the sole necessary institution for optimal allocations of resources wanes, other considerations must necessarily come into play.

The third reason for shortening value chains is tied to the urgency of the energy transition. With plummeting transportation costs, scattering the production process by locating each phase where it was most convenient allowed for cost minimization. But if environmental costs were considered, the calculation might have been different. Whether due to social pressure, to public action (through regulation or taxation), or simply to the awareness of imminent catastrophe, businesses will inevitably be driven to internalize part of the environmental costs of excessively long value chains. Repatriating some of the production processes, once environmental costs are properly considered, in the future might be the optimal choice.

Advocates of rethinking our production methods, in short, emphasize the necessity of not limiting oneself to the short-sighted maximization of monetary profits, but rather adopting a long-term perspective where resilience (including geopolitical) and social and environmental sustainability are appropriately considered.

Not throwing out the baby of globalization with the bathwater of excessively fragile value chains

While there is almost unanimity on the need to regain strategic autonomy for essential goods related to public health and national security, the voices against extensive reshoring for non-strategic goods are predominant. In recent decades, global value chains have been one of the pillars of trade expansion and economic growth in emerging and developing countries. A recent World Bank report estimates that, in the next ten years, reshoring by high-income countries and China would push 52 million people below the poverty line (especially in sub-Saharan Africa). The International Monetary Fund, in the April 2022 edition of the World Economic Outlook, after confirming that during the pandemic value chains contributed to exporting the economic crisis, notes that these negative spillover effects have decreased in intensity in the subsequent waves of the pandemic. This seems to indicate that value chains were more adaptable than initially believed.

In essence, those opposing a radical shortening of value chains recommend not throwing away the benefits of globalization due to excessively fragile value chains. Businesses should instead increase resilience through diversification of sourcing, better inventory management, and so on. It’s interesting to note that for decades it was advanced countries that pushed for globalization, while developing countries were vainly seeking protection due to the very well justified fear of being overwhelmed. Today, the opposite is happening: the debate on reshoring mainly occurs in advanced countries, while emerging countries strongly defend the global trade system.

Predicting what will happen in the coming years is difficult. What is certain, whether reshoring becomes significant or remains marginal, but businesses organize themselves to better absorb potential shocks, production processes will no longer be solely oriented towards cost minimization, and average costs will therefore increase. Higher production costs will necessarily impact prices and inflation.

This text is excerpted from a section of Oltre le banche centrali, available on August 25th from Luiss University Press.

The damage of monetary tightening is about to begin

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

The past weeks brought us four pieces of news on the inflation front. Well, actually, two pieces of news and two non-news. Let’s start with the latter. It is no longer news that central banks continue with their strategy of monetary tightening. Both the Fed and the ECB have raised rates by a quarter point, and the two presidents, Powell and Lagarde, are not revealing what will happen in September. What is certain is that, after the ninth consecutive hike, the rate for the eurozone is at its highest since 2001 when the ECB sought to support the value of the newborn single currency with high interest rates.

The second non-news is that inflation continues to decrease faster than expected. Data for France and Germany showed record lows since the invasion of Ukraine, while Spain’s inflation was slightly higher than expected. The tightening, therefore, continues while inflation falls. The official line of central banks is that this needs to happen because inflation has been “too high for too long,” and the risk is that it may become chronic, affecting expectations and wage negotiations.

No price-wage spiral

This argument is extremely weak, and, unfortunately i should add, there is no sign of wages chasing inflation. The OECD confirmed this only a couple of weeks ago in its 2023 Employment Outlook, which included a chapter on the generalized decline of real wages (a sign that nominal wages have grown less than prices).

Even expectations remain under control. After the two non-news items, the first news from last week is the results of the quarterly Survey of Professional Forecasters conducted by the ECB. According to the survey, professional forecasters expect inflation to return to 2% by 2024 (and to 3% in the last quarter of 2023). The ECB, on the other hand, continues to believe that reaching 2% will not happen before 2025. As a result, even among those who have supported the restrictive turn of the ECB in the past, voices calling for a pause in rate hikes are multiplying.

The decrease in inflation is mostly not due to the ECB

The hawks, on the other hand, base see the the decline in inflation as a justification of past rate hikes and as lending support for further increases in the autumn. The argument is that the tightening works and must continue until inflation returns to the 2% target. Unfortunately, this argument is flawed. The empirical literature has extensively studied the impact of central bank decisions on the economy. This mainly happens through the credit channel: the increase in central bank interest rates is transmitted to bank interest rates charged to businesses and households for investment projects and mortgages. The higher cost of capital implies less spending and and the cooling of the economy. This process is not immediate. While it is true that bank rates react fairly quickly to central bank decisions (especially to rate increases), spending is much stickier. For example, investment is a process that takes time, often years. It is unlikely that businesses will abandon an ongoing project just because the cost of money has increased. Therefore, the rate hike is transmitted with a certain delay, only as businesses complete ongoing investment projects and decide whether to start new ones. The same can be said for the other channel, that of exchange rates. The increase in interest rates causes an appreciation of the exchange rate and thereby a deterioration in trade balances, which cools the economy. Again, this process is not immediate because there are contracts to honor, spending habits to change, and so on.

For all these reasons, the transmission lags of monetary policy are measured in semesters, if not in years. The literature is abundant. A meta-analysis published a few years back tries to summarize these findings and reports that, on average, it takes 12-18 months to see the effects of a rate change on the real economy, and for the transmission to be complete, it takes about two and a half years. The delays are particularly long for countries with more developed financial systems, because there it is more difficult for the central bank to influence credit creation by the banking sector. This means that the impact of the credit tightening started in the spring-summer of 2022 is beginning to be felt now, and central banks have little to do with the decrease in inflation.

This brings us to the last news of the week, also from a survey. The results of the latest (July) quarterly Bank Lending Survey conducted by the ECB show (for the second consecutive quarter) a sharp decline in corporate credit demand (firms, anticipating an economic slowdown, are unwilling to borrow at increasingly prohibitive rates). Even for households and consumers there is a contraction in credit.

In short, while inflation has a life of its own, influenced only marginally by central bank decisions, these decisions are pushing us into an economic slowdown, which is showing multiple signals. In Germany, the Ifo business confidence index is at its lowest since last autumn, and the economy is stagnating after two quarters of slight contraction. Things are not much better in Italy, even though a recession is not currently forecasted in spite of negative growth in 2023 Q2. The “Congiuntura Flash” report published by Confindustria on July 29 shows a slowdown in the Italian economy mainly due to the weakness in industrial production and investment, with uncertain consumption and declining exports. Only the services sector (especially tourism) is keeping the Italian economy afloat.

We need to stop relying solely on central banks.

What does this picture tell us, besides the obvious fact that central banks persist in a futile and harmful strategy? First, in the coming months, measures will need to be implemented to mitigate the impact of monetary tightening, which will begin to fully unfold and, as usual, hit the most vulnerable categories. Second, the era of delegating the solution to all our problems solely to monetary policy must end. Since at least 2010, when the sovereign debt crisis began, monetary policy has been the only player in town, for better or for worse. It’s time to rethink the policy mix, the attribution of different economic policy tools and objectives to various actors. But this subject will need to be tackled in a future post.

Masochistic Germany is a problem for all of us.

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani ]

Recently, the German Minister of Finance, the liberal Christian Lindner, announced his intention, while preparing the budget law for 2024, to return to “fiscal normality.” This means reverting to the fiscal rule suspended in 2020 (the Schuldenbremse or debt brake), which mandates reducing the debt to below 60% of GDP. With the exception of defense, all ministries are supposed to face reduced allocations. Particularly noteworthy is the fact that the Ministry of Family Affairs, led by the Green Party’s Lisa Paus, will likely not be able to finance the child poverty reduction program which was a central focus of the government’s social protection agenda.

Lindner, a hawk who has been pressing for a swift return to budget discipline since the coalition government with the Greens and Social Democrats took office, likely has a dual objective. Internally, he aims to demonstrate his ability to steer the policies of the contentious and indecisive traffic light coalition. Externally, he seeks to influence the European debate on the rule that will replace the Stability Pact, showcasing his country as an example of fiscal probity.

Germany is pushing for the new European fiscal rule to be only a slightly revised version of the current one (suspended until the end of 2023), prescribing a swift return to public debt at 60% of GDP. The urgency for a large part of the German political class to close the chapter of Covid and return to an economy governed by frugality is striking.

This haste is puzzling for two reasons. Firstly, the German economy is facing a conjunctural crisis, with two consecutive quarters of (slightly) negative growth formally putting it in recession. Regardless of this, Germany has not yet recovered the activity levels of 2019 and ranks at the bottom among OECD countries in terms of growth since the pandemics. This under performance can be attributed to contingent factors, such as the impact of the War in Ukraine and the rising energy prices, which affected Germany more than others due to its geographical position and industrial specialization. However, there are also more structural factors, such as the struggling sectors where German firms are unable to keep up with technological innovation and competition from emerging countries. A notable example is the automotive industry, where German companies, leaders in combustion engines, lag behind in electric vehicles, in which China has gained a significant advantage. Under such circumstances, reducing public support to the economy through self-imposed austerity appears particularly self-harming.

Secondly, the myth of budget discipline so widely spread among German policy makers seems particularly incomprehensible because, even before the pandemic, the many years of past frugality, both public and private, were already taking their toll. Since the early 2000s, Germany has pursued a growth model driven by exports, based on domestic demand compression. Between 2000 and 2019, German business investment was significantly lower than the Eurozone average. Although the difference is less significant for public investment, it is only because public capital has grown at very low rates throughout the Eurozone. Germany had an average net public investment of zero between 1999 and 2015, while the Eurozone as a whole saw positive figures (albeit insufficient and declining during the sovereign debt crisis years). The Covid period, with its recovery in public and private investments, now seems to already be over. The result of this investment compression, especially in the public sector, is a capital deficiency that will constrain German growth in the coming years. The aging population will exacerbate this issue by reducing the labor force. Many studies associate the future aging population with further reductions in investment, labor productivity, and consequently, potential growth.

Even before the pandemic, there was a consensus among German economists that to address the infrastructural deficit accumulated since the early 2000s, Germany needed to engage in a massive investment program of around 40-50 billion euros annually for a decade. But in reality, the needs are much higher. After the pandemic, it became clear to everyone that the focus should not be limited (not just in Germany) to physical infrastructure alone. Social capital (education and healthcare, for example), which suffered greatly during the years of austerity, is equally important to ensure balanced growth. In 2018, a report coordinated by Romano Prodi estimated the EU’s annual social investment deficit at 100 billion euros. Last, but not least, the massive investment needs related to ecological transition and decarbonization of the economy will further increase the total amount.

In short, when considering the need to renew a crumbling infrastructure, the ambitious and indispensable climate objectives of the EU, the social capital deficiency (especially in healthcare, one of the ministries hit hardest by Lindner’s announced cuts), the additional investments needs become colossal. A group of economists I collaborate with for the European Public Investment Outlook series estimates these needs to be between 600 and 800 billion euros over the next decade, which is equivalent to 1.6% to 2.1% of GDP each year. It is evident that these figures are in no way compatible with the “debt brake” and the announced contraction of public spending. Ironically, during his inauguration speech, Chancellor Scholz spoke of the “government of investment”…

Things become even more complicated, making Lindner’s announcements even more baffling, when considering the timeline of investment needs. As my German colleagues argue, infrastructure investments can be spread over an extended period, allowing for modulation based on the need for counterciclicality (more investments during slowdowns and fewer during booms) and avoiding bottlenecks. However, decarbonizing the economy requires, due to the delays accumulated in previous years, that investments be made as soon as possible. These are mainly private investments (in transportation and thermal conversion of the building stock); but, as the German colleagues point out, for this massive effort to succeed, it must be accompanied and partly financed by the government through subsidies and tax incentives.

In conclusion, faced with a changing world, Germany seems to be turning backward, heedless of the fact that the old ordoliberal doctrine has proven to be woefully inadequate in preparing the country for future challenges. One might be tempted to comment that it’s their problem, not ours. However, that would be utterly mistaken. In the coming months, the debate on the reform of the Stability Pact will intensify. A German leadership stubbornly clinging to the past will be a problem for all of us.