The Chief Economist’s Note

The economics of Italy’s fiscal tightrope

Last week saw a further escalation in the standoff between the EU and Italy, with Brussels taking the unprecedented step of rejecting Rome’s budget plan for 2019. We’ve written about the simmering crisis in Italy at length, both from an economic and a market perspective. At the heart of the disagreement, however, is a deeper question about whether fiscal policy should focus on supporting growth or reducing the debt burden.

It won’t surprise you to hear that the economics textbooks offer no clear guidance.

In the simple Keynesian models that dominated academic thinking up until the mid-1970s, a fiscal stimulus boosts aggregate demand. And assuming the economy is operating below full employment (which Italy surely is), this results in an increase in output until such point that all of the spare capacity is exhausted.

But this thinking was challenged in the late-70s by the development of “rational expectations” models, in which citizens foresee that fiscal profligacy today means fiscal probity tomorrow and respond by ratcheting up saving. In these models, there is no impact on aggregate demand or economic growth.

Who should we believe? At Capital Economics we tend to view the world through a Keynesian lens. After all, in a world of rational expectations President Trump’s fiscal expansion should have had little impact on the US economy – but as I touched on last week, this is clearly not the case.

However, this Keynesian endorsement comes with an important caveat, which is that the economic consequences of a fiscal expansion depend to a large extent on the situation in which the country in question finds itself at the time.

In particular, if the decision to loosen policy sparks concerns about the trajectory of the public finances and causes bond yields to shoot up, the subsequent tightening of financial conditions can more than offset any boost to demand from the fiscal stimulus. This is why fiscal expansions in emerging markets can sometimes be counter-productive – and it accurately describes the situation in which Italy finds itself today.

Stepping back, the underlying problem in Italy is one of chronically weak economic growth against a backdrop of a large public debt stock, and all set within the constraints of a monetary union in which Italy’s central bank can’t stand behind the government bond market.

This creates problems because at low rates of economic growth, the arithmetic that governs the sustainability of the public finances becomes extremely sensitive to small changes in either the primary budget balance or government bond yields. And if that’s not bad enough, bond markets are also more likely to be spooked by any move to loosen policy by a highly indebted country operating within a monetary union (Italy) than they are by a highly-indebted country with its own currency (Japan). All of this leaves Italy walking a fiscal tightrope.

The uncomfortable truth is that any fiscal expansion is likely to do more harm than good to Italy’s near-term prospects, and it certainly won’t resolve the country’s longer-term problems of chronically low growth. It’s possible that this latest spat blows over and Rome backs down – after all, the EU has so far won all of its stand-offs with profligate governments. But if it doesn’t, this has the potential to reignite the euro-zone crisis – and on a scale much larger than that seen in 2010-14. This is something to which I’ll return in future notes.

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