The new Italian government of Prof. Mario Monti faces a deadly challenge with three formidable hurdles: the choice of the best economic policy strategy, the rapidly deteriorating context of the economic and institutional Europe, the trembling loyalty of his unprecedented majority of “the unwilling”.
Prior to addressing detailed measures, the government should choose a clear policy strategy. Monti is a learned economist as well as an experienced civil servant. His government is qualified as “technical”, not “political”. He knows very well that economists draw their raison d’être not only from the technical expertise that is necessary to master the intricacies of the economic system, but also because it is typical of economic life that decision makers face alternative means to achieve a given goal. Economists are expected to present alternative, consistent courses of actions, not to make specific policy choices, which are the realm of politicians, legitimated by the electoral mandate. Indeed, the Monti government has at least two alternative strategies on the “technical” table, but it will be called to make a choice, or at least to negotiate one with the parties sitting in the parliament, without being the expression of any one of them.
The first strategy is the well-known two-stages “shock therapy” à-la IMF, ECB etc. Blood and tears come first. The fiscal intervention is “front loaded”, and it must be a once-for-all adjustment as tough as necessary to shift public finances on a sustainable path. If the therapy is successful, the second stage almost comes as a free lunch: confidence is restored, the interest rate falls, consumption and investment restart, the economy recovers and grows again. This is by and large the recipe that Frankfurt and Brussels have sought to impose onto Rome, Mr. Berlusconi notwithstanding.
The second option is instead a medium-term strategy where fiscal adjustment is “back loaded”. It begins with measures of financial stabilization combined with supply-demand stimuli aimed at a) minimizing the recessionary impact of the initial fiscal correction, b) keeping the economy on a sustained trend that eases the subsequent fiscal consolidation. This strategy is predicated on two premises. The first is that the shock therapy is highly risky because it requires a number of favourable side conditions, typical of “small open economies”, that are unlikely to materialize for EMU countries (easy monetary policy, exchange-rate devaluation, expanding foreign trade). Absent these conditions, the recessionary impact of the therapy may be neither small nor transitory. If GDP falls faster than public debt, the economy falls into a disastrous vicious circle, as Greece testifies dramatically. The second premise is that the fundamentals of Italy would not justify an immediate liquidity or insolvency crisis, which is instead the product of a string of incredible mistakes of the Merkel-Sarkozy-Berlusconi trio that have triggered a sort of bank run on government bonds. Italy’s real problem is one of sustainability of public debt, and therefore the medium-term strategy is better suited.
The IMF-style “bureaucratic strategy” (R. Wilder, The Wilder View, 20-11-11) seems to have been discredited after its complete disaster in Latin America in the ’90s, except for the technocrats of the Brussels-Frankfurt Consensus, who keep prescribing it as the only possible solution for all possible problems. According to first indications and declarations, the Monti government seems in fact oriented towards the medium-term strategy, which presently enjoys wider support from independent experts. However, this option, too, has its own perils and pitfalls, especially for a “technical” government with limited time.
First of all, the medium-term strategy needs to borrow time from creditors. Growth as an antidote against blood and tears cannot be created by decree or overnight. Moreover, the surge of undeliverable expectations should be avoided. According to my calculations, in order to accomplish the SGP consolidation plan (1/20th of the debt/GDP ratio per year) while keeping the present primary surplus (0.7% of GDP) unchanged Italy ought to grow at a year rate of 6%-7% in nominal terms for the first ten years. With an average inflation rate between 2%-3%, real GDP should climb at 3%-4% per year. I add no comments about the realism of this promise. The ideal contractor of a new pact with Italy’s creditors would be a strong newborn government capable of making the credible promise to be in charge all the time that is necessary to keep the GDP on track and deliver the back-loaded fiscal adjustment. Monti might therefore opt for a mix of the two strategies, taking in the immediate stricter fiscal correction measures. I think that this unpalatable ingredient is necessary, and that it should be aimed not to nullify the current deficit but to obtain an immediate cut in the debt stock, which we badly need in order to make the subsequent path of primary surpluses less prohibitive.
In the second place, also the medium-term strategy is context-dependent. And our context consists of Europe’s institutions, markets and macroeconomy. None of these elements is playing favourably; quite the contrary. First, the strategy outlined above is not exactly the one that “Europe” advocates, and that was prescribed to the previous Italian government. On the other hand, it is legitimate that a new government seeks to renegotiate, and this is what probably (and hopefully) Mario Monti is aiming at in this week’s meetings with Barroso, Merkel and Sarkozy. Second, Europe’s macroeconomic scenario and policy stance make it all the more difficult to implement sustainable fiscal adjustments. The sovereign debts crisis of the euro countries is a systemic crisis in nature, largely due to an external aggregate shock that has vanished a ten years long process of fiscal convergence and has dramatically amplified the factors of divergence. Contrary to the Teutonic ideology of exclusive fiscal sovereignty and responsibility of good guys and bad guys, EMU dwells in a highly dangerous situation collectively, and it requires systemic solutions on two fronts: that of the institution of joint instruments of debt management (EFSF, ECB, Eurobonds, etc.), and that of consistent coordinated macroeconomic policies. Will this notion be clearer now that Germany’s exports are sinking and Mr. Schauble has witnessed the worst-received bond sale since the launch of the euro?
Look at the data in the following table. They highlight the correlation between a few growth indicators of each country with the average of the remaining countries (the so-called mean field effect). The first is GDP growth, the second is potential growth, the third is a measure of the business cycle (the difference between the previous two).
Correlation coefficients of selected variables between each country’s variable and the average variable of the remaining countries, 2000-10 (yearly data)
|GDP growth||Potential growth||Growth gap|
Source. Eurostat, AMECO database
It is unsurprising that these highly integrated countries display such strong correlations among themselves. The point is that the mean field effect for each country depends on what all the others are doing. Consider the case of Italy: if it alone implements a fiscal restriction of 1 point of GDP, it loses 1 point of GDP, but if all countries together implement the same restriction, Italy will lose almost 2 points of GDP (the same more or less happens with all the other countries). If the Germans think they are immune from the euro disease only because (perhaps) they do not need a domestic fiscal correction, they may be disillusioned because they will be affected by the fiscal restrictions imposed onto the others. You may not believe it, but, as far as I know, these simple calculations are not present in the homeworks that the Brussels technocrats hand out to each government. Italy has to do its own homework, but the fallacy of composition of all homeworks may result in the general failure of Europe.