Yves her. This is a particularly clear and concise explanation of why the models that the European Commission has used to argue against Italy’s proposed budget deficits are rubbish.
By Orsola Costantini, Senior Economist, Institute for New Economic Thinking. Published at the Institute for New Economic Thinking website
Reactions to the size of the proposed plan rely on discredited assumptions and betray a fundamental misunderstanding of economic growth—and austerity
Nothing stirs the souls these days like a new fiscal plan. If that plan belongs to the (maybe second) most controversial government in the European Union, the Italian Five-star and Lega coalition government, commotion is guaranteed.
On September 27th, Italian finance minister Giovanni Tria communicated to the European Commission the intention to make changes to the budgetary plans set by the previous government. “The new plan would generate a deficit to GDP ratio of 2.4% in 2019, implying a structural budget balance to GDP ratio of -0.8%, that is a projected deviation of 1.4% from the target.
Financial markets and the media reacted sharply. Pierre Moscovici, European Commissioner for Economic and Financial Affairs, and European Commission President Jean Paul Juncker both expressed dismay, while the 10-year bond yields rose above 3.5% for the first time in four years. The Deputy Prime Minister and leader of the Five-star movement, Luigi Di Maio, commented that “there are some European institutions which, with their statements, are playing at terrorism on the markets.” On October 5th, the official letter of the European Commission responding to the minister expressed “serious concern” about the planned changes, generating further market turmoil. On October 9th, the International Monetary Fund (IMF) and the Italian central bank joined the chorus with new negative warnings.
Italian government leaders responded fiercely that they would not retrench from their plan, and directly and openly criticized the European establishment. Even the moderate face of the coalition, the Italian Premier Giuseppe Conte, stepped up to question the priorities of the European Commission, the Bank of Italy, and the IMF: He assured that his government remains committed to containing the public debt and maintaining fiscal stability, but claimed that goal is impossible to achieve without economic development. The minister for European affairs, economist Paolo Savona, said that, in fact, a higher deficit-to-GDP ratio than 2.4% would be helpful.
The heated reactions to the new fiscal plan are unjustified. In fact, the estimated targets that the new fiscal plan would (minimally) breach are unreliable and based on wrong macroeconomic principles. Moreover, despite accusations of profligacy, Italy has in fact been running large primary surpluses (the budget balance minus interest payments), and will keep doing so even if the government confirms its plans (see figure 1). If anything should be of “serious concern,” it is the fact that the country continues down the road of austerity, which has proven to be contractionary; it has locked the country into stagnation and exposed its banking system to still more stress. With public investments at historically low levels, unemployment still above the 2008 rate in all regions, and a youth unemployment rate above 30%, it is hard not to see a strong case for fiscal stimulus.
Figure 1 Source: ECB Statistical Data Warehouse
The letters between the government and the European Commission are nothing extraordinary: The correspondence is part of the European Union’s strictly scheduled and regulated procedures of fiscal surveillance. Nor was the negative judgement in the Commission’s letter new to Italian government officials. In October 2017, for example, the Commission sent a similar letter to the then-finance minister Pier Carlo Padoan, responding to the government’s proposed budget for 2018 and following years, complaining that the plan would deviate by 0.4 percentage points from the agreed-upon target for 2018:
For 2018, [the draft budget] plans a structural effort of 0.3% of GDP, which once recalculated by the Commission services […] amounts to 0.2% of GDP. This structural effort is below the effort of at least 0.6% of GDP required according to […] the Stability and Growth Pact […].” The Commission concluded: “This points to a risk of a significant deviation from the required effort in 2017 and 2018 together. We would thus welcome further Information on the precise composition of the structural effort envisaged in the [draft fiscal plan].
What is more interesting is the follow-up letter from Padoan at the time, who expressed concerns about the commonly agreed methodology for estimating the figures under discussion:
“Italy is still experiencing difficult, though improving, cyclical conditions. The output gap is estimated at -2.1 percent of potential GDP in 2017 and -1.2 in 2018. The Commission’s estimates in the Spring Forecast were -0.8 percent for 2017 and 0.0 for 2018. In view of a likely revision of the real GDP growth projections in the upcoming Autumn Forecast, these figures are pointing to a positive gap in 2018 – a result that we feel is at odds with all the available macroeconomic evidence […]”
Eventually, the Commission and the Council accepted the budget plan and did not initiate a formal Excessive Deficit Procedure (which could lead to sanctions). But the methodological questions Padoan raised remained fundamentally unanswered. Are they still valid today?
The European Union uses several indicators of fiscal soundness to judge whether a country is progressing toward its Medium-Term Objective. Those are, broadly: the debt-to-GDP, budget balance-to-GDP, primary budget balance-to-GDP, and the structural budget-to-GDP ratios.
Forecasting the dynamics of the debt and budget balance-to-GDP ratios implies a certain degree of uncertainty regarding income growth and its components. But when it comes to structural budget and output gaps, which was Padoan’s concern, the story becomes even more complicated. Those estimates amount to masterpieces of statistical disguise.
They require an evaluation of how the country is growing relative to its potential. But the latter, of course, is not observable. So its estimation requires a model of how fiscal policy and, more generally, public policies, affect growth.
Needless to say, there is no consensus in economics about such a model. Many established scholars, such as Olivier Blanchard, formerly chief economist at the IMF, have criticized the methodology eventually adopted by the European Commission. The Commission itself seems a bit confused about is results, given the continuous revisions of the output gap for Italy, as Padoan points out in his letter (figure 2).
Figure 2: Estimates of Output Gap for Italy by the Commission at different times. Colors show the year in which the estimate is made and the dots show the years to which the estimate refers. Source: EUROPEAN COMMISSION DIRECTORATE GENERAL ECONOMIC AND FINANCIAL AFFAIRS, Assessment of Italy’s Stability Programme from 2014 to 2018 (Spring estimates)
But besides unreliability, this formula has a more substantial problem: It assumes in its construction that public deficit spending cannot have a structural impact on growth. This means that an increase in deficit cannot stimulate growth without inflation, and that a decrease in deficit does not have depressive effects. As a result, any fall in the rate of growth cannot, by construction, ever be interpreted as a result of austerity.
This assumption is at odds with what even prominent mainstream economists now say.
So what does determine potential output, according to the Commission? An important component, and one to which we can probably all relate, is the structural unemployment rate, or Non Accelerating Wages Rate of Unemployment (NAWRU)—i.e., the lowest unemployment rate at which wage growth does not accelerate and lead to inflation. Figure 3 below shows how the latter hypothetical construction behaves relative to the actual unemployment rate. The difference between the two series is relevant: The larger the difference, the larger the output gap—and hence the fiscal space allowed to a country.
But somehow the higher the actual rate, the more the structural rate, thus leaving the output gap essentially unchanged.
Figure 3: In blue the actual unemployment rate and in red the NAWRU, data downloaded from AMECO in 2013, at the peak of the sovereign debt crisis. The Commission estimated at the time that Spain had a 24% optimal rate of unemployment.
The rationale is clear: The assumption is that unemployment is due to structural factors, like labor market rigidity, and fiscal deficits can seldom help for that. Even if we believed that, it would be hard to explain why Spain in 2004 had a structural unemployment rate of 10.4% and 24% in 2013, given that the labor market had by then become more flexible. In Italy, the unemployment rate for 2018 is currently at 10.8%, and the NAWRU estimate is 9.94%.
But technical debates aside, the decision is ultimately political. The obscure formulas and shaky models lend themselves to just that: justifying what is decided behind closed doors. In the meantime, however, the statistical gibberish will have diverted the Europeans’ attention from a discussion about the broad social goals Europe should attain.
Still, it is hard to understand why, in a political context that threatens the foundation of the EU, the European Commission has decided to evoke the specter of a financial catastrophe over a 1.4% point increase in an estimate—one that has proven repeatedly unreliable and that a majority of economists would contest.
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Completely agree, the models of output gap are rubbish. But the economists at the Commission know that (there are frantically trying to save the concept by changing the methodology) and the assessment of a fiscal plan is based on much more that just the structural balance. The Stability & Growth pact manual runs to hundred of pages and, if there is a will, there is actually a lot of flexibility (just watch how higher-ups in the French economic minister have been able to convince for years the Commission that France was doing a lot of efforts, yes I’m proud of them, they have been doing god’s work).
Now the problem with Italy’s plan is not that they are targeting 2.4%. It is, first, that 2.4% is based on very optimistic assumptions of growth and spending/revenues. It is likely that the real target is closer to 3%, perhaps even above. Here the problem is as much the number as the return to fantasy accounting. The second problem is that they are turning this into a public confrontation with European institutions. How can the Commission accommodate a fiscal expansion and the ECB stand behind it when Salvini/Di Maio are basically saying they don’t need them and can do what they want ?
I do think that the Italien economy could use a fiscal stimulus and in an ideal world a push to 3% would make a lot of sense. Though actually, Italy could already find a lot of fiscal space if spread went down. Roughly, they could spend 1% GDP more by just publically saying they would respect fiscal rules. Add to that the flexibility the Commission has shown (France but also Spain) and they could even more than the spending they have just promised. Once again, it would be less than what would be ideal but nothing is perfect and threatening to spend as much as you want in a currency you don’t control is just asking for troubles.
Thank you and well said, French Guy.
From comments made by Italian government and, talking out of turn, EU officials made an at a City event to discuss such matters in mid-July, they get it and agree with what you say. The German(ic) core / optimal currency area and their comprador class on the periphery won’t hear of such impurity.
I think that the flexibility you mention depends on the governments pledged at least nominally to EU rules, being conventional –not “populist”– and promising a come back to rules ASAP. In the case of Italy, they are challenging EU rules on a more comprehensive way. They also commit the sin of being populist and that is too much for the commision to show any flexibility, me thinks. My opinion is that this has nothing to do with confrontation between economic models/forecasts which are just used as weapons to justify one’s ideological posture. As you correctly say
“the second problem is that they are turning this into a public confrontation with European institutions”
Which I believe is a big mistake for the Italian government to make. They should frame the confrontation simply as ideological rather than institutional. While we are focusing on Italy, meanwhile in Spain the socialist party is also introducing policies that increase public expenses (increasing public pensions) in line with Salvini’s gov and this is more or less passing without noises –except the typical warnings from the IMF and the Commision that nobody seems to atend so far. The difference is in the defiant tone that Salvini’s government is using.
I wish that the course of action of the current italian government was founded on a critique of EU fiscal rules as sound as the one evidenced here. There’s now a widespread awareness in Italy that austerity is self-defeating (it was never a welcome concept anyway), but that is going to be leveraged by our two prime ministers to hand over some populist measure in deficits in order to reap the rewards on the coming EU parliament election. The measures involve transfer payments for the most part (financing current spending with borrowing isn’t good fiscal practice) and there’s little effort in trying to inject a structural positive shock that can promote endogenous growth. Oh and there’s also a backtracking on previous reforms (pensions).
So instead of making a strong case against EU fiscal rules, which would be welcome, this government is doing some serious damage by antagonising the EU and many others (italian central bank and independent agencies, research centers, most of the press) over a battle that is correct in principle but flawed in execution. The commission will have an easy time rejecting the budget, Italy will be crushed by market forces and a good chunk of italians will entrench and radicalize even more. At the end we will end up with reinforcing the notion that we need more fiscal moderation and that italians are profligate and irresponsible and should be disciplined with more austerity. I can see it already.
Alt’s phrase today – “the possibilities of modern fiat money” as a means to achieve social goals is interesting. Germany and the EU seem to face these possibilities with the same aversion our congress does. It sometimes makes me wonder if they are terrified by the thought. Clearly, our once socially benevolent democrats are not ready. Is it because it serves them to be so vested in scrooge-distribution of social benefits? And why would that be? Reminds me of gangsters dealing in contraband – the way they dole out a scrap here and a scrap there. This is certainly no way to face the future. Germany will be scaling back its famous automobile/industrial economic base. Not because they want to but because we are moving beyond the age of the automobile – or we’ll face planet-wde catastrophe. So the question Germany must ask itself is, What will we do then, when we are in the same boat as Italy? Will we embrace the possibilities of modern fiat money and thereby finally create an EU wide sovereignty? I certainly hope they can get past their current refusal to embrace the obvious future. It’s really fitting that Greece is finally suing Germany for WW2 reparations. Couldn’t happen to nicer guys.