Cut Italy some slack

In the last few days the market has been getting worked up about the new Italian government and its deficit plans. Italy is well known to have the largest debt burden in the EU, and the largest as a % of GDP after Greece, and after all the problems Greece caused it is not surprising that expansion of Italy’s budget deficit is view with concern. But a bit of perspective is necessary. First of all, the proposed rise in the deficit is only to 2.4% of GDP – below the EU guideline limit of 3%. The Italian deficit has only been lower than this in three years since 2000, so this is hardly an unprecedented blowout. But the EU will not be criticising Italy for exceeding deficit guidelines, but for failing to do enough reduce their debt – which is currently at 130% of GDP, well above the EU guideline of 60%. To that extent, EU concern is understandable, but looking a little more closely it is hard to argue that this debt should be a major concern.

The debt level is a concern if it is rising year on year and starts to spiral out of control. But this is currently not the case in Italy, where the debt level has been stable since 2014, partly because Italy is running a primary budget surplus, as it has for many years, partly because the yield on Italy’s debt, and consequently Italian debt interest payments, have been falling steadily. So much so, that even though the debt level is close to its highs at 130% of GDP, net debt interest payments are at the lowest level since 2000 (and long before that) at 3.5% of GDP.

To determine the level of the deficit that is needed to reduce the debt level we need to do a little maths. Leaving aside some technicalities, the primary surplus needs to be greater than the debt level multiplied by the difference between the nominal growth rate and the nominal interest rate. Or:-

p > D(g-i) where p is the primary surplus, D is the debt level, g is the growth rate and i is the average debt yield.

In Italy’s case, D=130, and i=2.7%. g is the biggest problem, as this is averaging only around 2% in the last few years. Still, on that basis we need p> 130(0.02-0.027) = 0.91.

If Italy runs a deficit of 2.4% of GDP, with debt interest payments of 3.5% of GDP, it is running a primary surplus of 1.1% of GDP. This is lower than we have seen in recent years, but still greater than 0.91% and enough to keep the debt level stable, albeit barely reduce it.

Now, this is all very well for now while yields are low, but, you may ask, what happens if yields go up in the coming years as they seem likely to do when the ECB stops its QE and starts raising rates? This is a fair question, but Italy has protected itself to some extent by extending the average maturity of its debt to 7 years, so that any rise in yields will take some time to have a major effect.

But the bigger picture is this. The best way for Italy to exit the debt trap is to boost its (nominal) growth rate. While we can argue about the best way to do that, a modest fiscal boost won’t do any harm, while the impression that they are subject to an EU strait-jacket will not help. There are some minor signs of improvement in the Italian economy. The long term unemployment rate has started to fall, the growth rate has picked up modestly, and the current account is in increasing surplus. This, by the way, suggests that the Italian private sector is saving too much and holding back growth. A little more government spending and some boost to consumer confidence could be what is needed to keep growth accelerating.

While Italy’s debt does need to be dealt with in the longer run, the EU should see that attempting to impose austerity is not going to work either economically or politically. Trying to slap the new government into line will only foment more disaffection with the EU and likely create an even more anti-EU political movement. In any case, there isn’t much the EU can do to stop Italy’s government doing what it plans in the short-term. Things like the excessive deficit procedure take a long time to kick in and are pretty ineffective anyway. The biggest discipline on Italy will be the markets, and the best way for the EU to help Italy is to encourage the markets to cut Italy a little slack.

 

 

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