I already noticed how the post-Jackson Hole Consensus is inconsistent with the continuing emphasis of European policy makers on supply side measures. In these difficult times, the lack of a coherent framework seems to have become the new norm of European policy making. The credit for spotting another serious inconsistency this time goes to the Italian government. In the draft budgetary plan submitted to the European Commission (that might be rejected, by the way), buried at page 12, one can find an interesting box on potential growth and structural deficit. It really should be read, because it is in my opinion disruptive. To summarize it, here is what it says:
- A recession triggers a reduction of the potential growth rate (the maximum rate at which the economy can grow without overheating) because of hysteresis: unemployed workers lose skills and/or exit the labour market, and firms scrap productive processes and postpone investment. I would add to this that hysteresis is non linear: the effect, for example on labour market participation, of a slowdown, is much larger if it happens at the fifth year of the crisis than at the first one.
- According to the Commission’s own estimates Italy’s potential growth rate dropped from 1.4% on average in the 15 years prior to the crisis (very low for even European standards), to an average of -0.2% between 2008 and 2013. A very large drop indeed.
- (Here it becomes interesting). The box in the Italian plan argues that we have two possible cases:
- Either the extent of the drop is over-estimated, most probably as the result of the statistical techniques the Commission uses to estimate the potential. But, if potential growth is larger than estimated, then the output gap, the difference between actual and potential growth is also larger.
- As an alternative, the estimated drop is correct, but this means that Italy there is a huge hysteresis effect. A recession is not only, as we can see every day, costly in the short run; but, even more worryingly, it quickly disrupts the economic structure of the country, thus hampering its capacity to grow in the medium and long run.
The box does not say it explicitly (it remains an official government document after all), but the conclusion is obvious: either way the Commission had it wrong. If case A is true, then the stagnation we observed in the past few years was not structural but cyclical. This means that the Italian deficit was mainly cyclical (due to the large output gap), and as such did (and does) not need to be curbed. The best way to reabsorb cyclical deficit is to restart growth, through temporary support to aggregate demand. If case B is true, then insisting on fiscal consolidation since 2011 was borderline criminal. When a crisis risks quickly disrupting the long run potential of the economy, then it is a duty of the government to do whatever it takes to fight, in order to avoid that it becomes structural.
In a sentence: with strong hysteresis effects, Keynesian countercyclical policies are crucial to sustain the economy both in the short and in the long run. With weaker, albeit still strong hysteresis effects, a deviation from potential growth is cyclical, and as such it requires Keynesian countercyclical policies. Either way, fiscal consolidation was the wrong strategy.
I am not a fan of the policies currently implemented by the Italian government. To be fair, I am not a fan of the policies implemented by any government in Europe. Too much emphasis on supply side measures, and excessive fear of markets (yes, I dare say so today, when the spreads take off again). But I think the Italian draft budget puts the finger where it hurts.
The guys in Via XX Settembre dit a pretty awesome job…
A follow-up of the post on public investment. I had said that the resources available based on my calculation were to be seen as an upper bound, being among other things based on the Spring forecasts of the Commission (most likely too optimistic).
And here we are. On Friday the IMF published the result of its Article IV consultation with Italy, where growth for 2013 is revised downwards from -1.3% to -1.8%.
In terms of public finances, a crude back-of-the-envelop estimation yields a worsening of deficit of 0.25% (the elasticity is roughly 0.5). This means that in the calculation I made based on the Commission’s numbers, the 4.8 billions available for 2013 shrink to 1.5 once we take in the IMF numbers. It is worth reminding that besides Germany, Italy is the only large country who
can could benefit of the Commission’s new stance.
And while we are at Italy, the table at page 63 of the EC Spring Forecasts (pdf) is striking. The comparison of 2012 with the annus horribilis 2009 shows that private demand is the real Italian problem. The contribution to growth of domestic demand was of -3.2% in 2009, and -4.7% in 2012! In part this is because of the reversed fiscal stimulus; but mostly because of the collapse of consumption (-4.2% in 2012, against -1.6% in 2009). Luckily, the rest of the world is recovering, and the contribution of net exports, went from -1.1% in 2009 to 3.0% in 2012. This explains the difference in GDP growth between the -5.5% of 2009 and the -2.4% of 2012.
Italian households feel crisis fatigue, and having depleted their buffers, they are today reducing consumption. I remain convinced that strong income redistribution is the only quick way to restart consumption. Looking at the issues currently debated in Italy, this could be attempted reshaping both VAT and property taxes so as to impact the rich and the very rich significantly more than the middle classes. The property tax base should be widened to include much more than just real estate, and an exemption should be introduced (currently in France it is 1.2 millions euro per household). Concerning VAT, a reduction of basic rates should be compensated by a significant increase in rates on luxury goods.
Chances that this will happen?
Yesterday I published a note on OFCE le blog (in French), analyzing one possible outcome of the recent Italian elections: A center-left minority government, with external support of the Cinque Stelle movement led by comedian Beppe Grillo. The last part of the post argues that if a convergence between the Democratic Party and Beppe Grillo were to be found (at the moment the scenario is rather unlikely), it would happen on a number of progressive issues, like for example minimum citizenship income. But then, I conclude, this has implications for Europe as a whole. Here is a translation of the last paragraphs: It is clear that the convergence could hardly happen within the bounds of the current fiscal consolidation. An agreement would therefore need a prior reversal of austerity that, it is worth repeating, was disavowed by the voters. This would not be easy for the Democratic Party that, like the Socialist Party in France, made the choice of fiscal discipline, and has kept a very ambiguous position along all the electoral campaign. But in turn, this has implications for Europe as a whole. European leaders in the next weeks may face a choice between demanding that Italy stays the course of fiscal consolidation, condemning the third economy of the eurozone to political paralysis and probably social chaos; or, accept that a new government is formed, that will most likely abandon austerity. In both cases it will be impossible to act as if nothing had happened. Europe could be forced to rethink its own economic strategies, that are failing not only in Italy. An some countries reluctantly embracing fiscal consolidation (France to name one) could take the opportunity to challenge austerity as the only policy for growth.
Let’s be clear, here. I am totally aware that at the moment this is nothing more than wishful thinking. But hey, you never know…
The run up to the Italian elections in February is a welcome occasion to come back to the issue of austerity. The debate in Italy was fired by the widely discussed Wolfgang Munchau editorial, blaming Mario Monti for not opposing austerity. In the heat of electoral competition, this unsurprisingly stirred harsh discussions on whether Italy has room for reversing the austerity that ravaged the country. Some commentators got slightly carried away, accusing those opposing austerity of “silliness and falsehood”. I wonder whether they include the IMF chief economist in the bunch… Whatever, this is a minor issue; the way I see it, these discussions totally miss the point.
The upcoming Italian elections triggered an interesting debate on the choices ahead, and on the role of technocratic governments. A few days ago the Italian journalist Barbara Spinelli published on the daily La Repubblica a masterly analysis (in Italian) of the difficulties faced by a political sphere that seems incapable, or unwilling, to reclaim from technocrats the task of governing, by which I mean the right/duty to choose between policies with different economic and social consequences.
To an economist, Spinelli’s analysis is a source of further thoughts on the role of choice in economic theory and policy, with important consequences not only for Italy but also for the path that the European construction will walk in the coming years.
Istat, the Italian statistical office, just released its Quarterly non-financial accounts for the General Government. As were to be expected, deficit is spiraling out of control (8% on the first quarter, against 7% in 2011), because of higher borrowing costs, and because the economy is doing very poorly.
Two days ago they released the provisional unemployment figures for May: stable above 10% (youth unemployment is at 36.2%!).
It seems that we come full circle, robustly installed in a Recession-Deficit-Austerity-Recession-Deficit-and-so-on spiral.
Austerity works, right? Why on earth, should Italy aim for a balanced budget in 2013? Is this required by current European rules? No(t yet). Is this reassuring markets? No. Is this boosting private expenditure? No. Is this killing the Italian economy? Yes.
Ah, and if at least we did something for those spreads…
The April data on Italian unemployment are out, and they look no good. Not at all. The overall rate (10.2%) is at its maximum since the beginning of monthly data series (2004), and youth unemployment is above 35%. The rest of Europe is not doing any better, with more than 17 millions people looking for a job in the eurozone alone.
We already knew. The latest data just add to the bleak picture. We also know (I discussed it) what the consensus diagnosis is: Too many rigidities, excessively high labour costs, both because of wages and of taxes on labour (the so-called tax wedge). Therefore, let’s have lower wages, and all will be well! Unemployment will disappear, growth will resume. Mario Draghi said it rather nicely:
Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.