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.
