Events are still unfolding, but the center-left Democratic leadership has given an explicit thumbs-down to the current government, and former Prime Minister Enrico Letta has resigned. Matteo Renzi, the leader of Italy’s Democrats, says that he hopes to have his new government ready this weekend after nearly two days of talks with all of Italy’s political parties, and expects to form a coalition largely based on the same left-right alliance that previously supported Letta.
So is anything going to change? As is often the case with progressives, they are pinning their hopes on a change at the top delivering a real kind of progressive change of politics. But as we have learned here in the United States, change can be tricky, particularly when the institutional constraints are so severe, as is the case for Italy or any other country within the European Monetary Union.
Euro zone countries have faced two types of problems by entering the euro regime. First, they have surrendered their monetary sovereignty by giving up their national currencies and adopting a supranational one. By divorcing fiscal and monetary authorities, they have relinquished their public sector’s capacity to provide high levels of employment and output.
Non-sovereign countries are limited in their ability to spend by taxation and bond revenues, and this applies perfectly well to Italy, Spain, Greece, and even to countries like Germany and France. Note that currently no U.S. state has a budget deficit relative to its gross domestic product that comes close to those of Greece or Italy, but that at the height of the U.S. financial crisis states such as California were already meeting market resistance to any new borrowing precisely because they are recognized as non-sovereign.
I suspect that euro zone nations have been allowed to exceed the limits imposed on U.S. states because there is some market uncertainty about the nature of these nations. Are they non-sovereign? Will their neighbors come to their rescue? Will the European Central Bank or International Monetary Fund rescue individual nations?
ECB President Mario Draghi, has said he would do “whatever it takes” to save the euro. But the promise has come with a sting attached. In exchange for the ECB’s “help” the countries that fall under its as yet untested “outright monetary transactions” program, also known as OMT, will have to adopt even more budgetary cuts, which will simply exacerbate the problem of higher deficits and slower growth.
In addition, by entering the euro zone these countries have also agreed to abide by the Maastricht treaty, which restricts their budget deficits to only 3 % and their debt levels to 60% of GDP. Therefore, even if they are able to borrow and finance their deficit spending, like Germany and France, they are not supposed to use fiscal policy above those limits. So countries have resorted to different means to keep their national economies afloat, from trying to foster the export sector, as Germany does, to cooking the books through Wall Street wizardry, like Greece did.
The Maastricht constraints have proven to be flexible, but that does not mean that they do not matter. When a nation exceeds mandated limits, it can face punishment by European institutions and also by markets. There is competition among the nations of the euro for ratings—with Germany usually winning, which enables it to issue euro debt at a lower interest rate. This in turn keeps its interest spending and deficits lower in a nice virtuous cycle. In turn, nations that exceed the limits by the greatest amounts are punished with high interest rates that drive them into a vicious death spiral because their deficits rise and lead to further credit downgrades. That is what happened to Greece.
It also means that whatever Renzi promises, he actually is significantly limited in terms of what he can do. Renzi is right to focus on the arbitrary stupidity of the budgetary limits imposed by virtue of the “Stability and Growth Pact” because budget deficits are fundamentally symptoms of slower growth, not the cause. A larger deficit arises when unemployment rises, incomes fall, tax revenues diminish and social welfare expenditures increase. Growth tends to cause things to go in the other direction.
So how to achieve growth?
The concern is that Renzi focuses too much on so-called “supply side” reforms (which is usually code for making it easier to fire workers) as Europe suffers primarily from a problem of poor aggregate demand. Perhaps he is doing this to appease public opinion in Germany. But at the end of the day a better political-economic approach would be to make the case that if one really hates public debt and deficits, then the embrace of a growth program is the best way to deal with this problem rather a fixation on arbitrary targets that have no basis in any kind of economic theory.
The other alternative is the so-called “nuclear option,” where a nation such as Italy would use the threat of withdrawal from the euro zone in order to force a change of stance on the part of the creditor nations (i.e. Germany), which has much to lose in such a circumstance. Italy certainly could go it alone. It has a vibrant manufacturing sector and produces a whole host of goods that the rest of the world covets, so securing foreign exchange would not be an issue.
However, as I point out in the interview Il Foglio linked below, the problem with a nuclear option is it creates a lot of collateral damage if you use it. This is why I suspect we’ll end up with more public talk from the ECB and the so-called “Troika” about the need for continued reform of public finances, while quietly letting it slide so as to avert an even greater social catastrophe than is now being experienced across the continent.
In this regard, you can expect no dramatic change from Matteo Renzi.
