Interest is high in how Italy is going to pull a Budget together by the deadline of September 27th. This worry highlights again a significant structural weakness in the construct of the common currency – the lack of an overarching Eurozone-wide fiscal strategy. Lack of fiscal integration remains a key vulnerability for the common currency.
The new populist Government was elected on a mandate that included the introduction of a flat tax, a universal basic income and the reversal of recent pension reforms. This combination of policies was impossible if the new Government were to remain within budget limits set by Brussels.
We have long been believers in the discipline markets bring to profligate fiscal promises. Loose fiscal talk in the period since the election has seen a negative reaction in markets. Bond yield have sold off considerably, raising the servicing cost of Italy’s already unsustainably high level of public debt.
So it’s no surprise that the leaders of both the Five Star Movement and the League have backed off some of their fiscally expansionary rhetoric over the last few days. There seems to be an acknowledgment that you can’t just do what you say you are going to do without some market reaction, and with that some discipline brought to bear.
The reality is that Italy has one of the worst fiscal positions in Europe, with a gross debt to GDP ratio of 130%. Fiscal policy is already tight with the country running a primary budget surplus (ie surplus before debt servicing costs) that optimistic International Monetary Fund (IMF) forecasts expect will increase over time, indicating Italy fiscal policy will become even tighter. At the same time, the IMF expects Italy to achieve a markedly higher level of nominal GDP growth than has been produced over the decade since the Global Financial Crisis.
It is that high debt burden, along with dismally low productivity growth, that continues to constrain overall economic growth. Italy’s per capita GDP remains around 2% below the level prior to the financial crisis, and on the current trajectory will take the best part of another decade to get back to that level.
Even before the election, the country’s new political leaders realised that leaving the Eurozone was not a viable option. We agree. But the problem is fundamentally about growth, and since the new government was elected the growth outlook has deteriorated, leading to a deterioration in the outlook for Italy’s public finances.
So here we are again, eight years on from the onslaught of the Eurozone debt crisis, still worrying about the fiscal sustainability of the Eurozone’s third-largest economy.
It is therefore with some delight that we note recent support from Germany’s Angela Merkel for French President Emmanuel Macron’s concept of a Eurozone budget. What that may look like and how long it may take to get in place is moot, but at least there is a conversation.
We’ve often mused on the fact that any structural improvements in the Eurozone have come at times of crisis. It would be great if this time the Eurozone was a bit ahead of the game.
We worry that the Eurozone is already past the peak in its growth cycle and while we expect growth to remain ahead of its non-inflationary potential for a while yet, our concern is that when growth turns down more sharply there may be limited gas in the stimulus tank.
The European Central Bank will only end its asset purchase programme at the end of this year, and it is not expecting to raise interest rates until the end of 2019. The risk is by the time more stimulus is required, the European Central Bank will have limited room to move.
That means fiscal policy will need to play an important role in providing that stimulus. And without more comprehensive fiscal integration, we worry about fresh vulnerabilities for the common currency.
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