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May 5, 2013 8:37 pm
There is a big buzz in Europe that austerity may soon be ending. The Italian elections have scared politicians in other parts of southern Europe. The European Commission seems sympathetic, too. As a consequence, I would expect to see minor small-print policy shifts. However, the main change will not be about policy itself, but the way it is sold.
A good example of the new PR-based anti-austerity strategy came in speeches last week by Enrico Letta, Italy’s new prime minister. He railed against austerity, but at the same time emphasised his commitments to Italy’s fiscal targets, as if the two were somehow unrelated.
He is planning to suspend an unpopular property tax, which would punch an €8bn hole in his budget if it were abolished. Now we are hearing that his government is working on a replacement tax to fill that gap.
My guess is that Italy will probably stick to the structural deficit reduction plan. However, because economic growth will be lower than previously expected, there is a good chance that nominal deficits will overshoot their targets. The most likely change in policy will be to allow that overshoot to happen, at least in part.
To see in more detail why the change is going to be so limited, one has to understand the sheer scale of austerity in the 2012 and 2013 budgets.
The structural government balance for Italy was -3.6 per cent of gross domestic product in 2010 and -3.5 per cent in 2011. However, in 2012 it jumped to -1.3 per cent, according to the data from the April World Economic Outlook by the International Monetary Fund. The forecast for 2013 is for another jump to -0.2 per cent of GDP. So the accumulated adjustment in 2012 and 2013 is projected at about 3.4 per cent of GDP.
This extreme fiscal correction has caused the current recession, the extent of which was underestimated by the European Commission and the previous Italian government.
What will happen now? European policy makers have some flexibility in their ability to trigger a clause in the economic governance framework of the eurozone, allowing them to adjust the targets during recessions.
The eurozone has come a long way from when the rule consisted of an inflexible nominal 3 per cent target. The 3 per cent rule still stands, but the main focus is now on structural deficits. This is an improvement, but in the way the framework is applied it remains pro-cyclical, though perhaps not to quite the same extent as before.
In addition, Italy may also be released from the excessive deficits procedure, which would provide some additional flexibility by releasing funds for investment that are currently blocked.
The slight moderation in the pace of austerity offers a further advantage. There will be less collateral damage from Italy’s hastily decided spending cuts. The Italian government applied austerity not so much by consuming less, but by simply not paying for services. Italy now needs to introduce a new law to allow the resumption of those payments. I would classify this behaviour as default.
The effect of a shift in strategy is therefore larger than zero, but still not much. The eurozone continues to move towards structural balance, in contrast to the US, the UK and Japan. Fiscal policy will continue to have a negative effect on growth.
If the eurozone were serious about a U-turn on austerity, the only effective way to accomplish this would be for the creditor countries to expand their fiscal positions during the recession. The opposite is happening.
Germany, a country with a lot more fiscal space than Italy, undertook a fiscal adjustment of almost similar scale. Between 2010 and 2012 the accumulated net improvement of the structural balance was 2.5 per cent of GDP. Italy and Germany are both projected to record structural balance, more or less, this year and in 2014.
There is no way that Germany in particular will accept a fiscal stimulus for the sake of the southern European countries. This is because Germany restrained itself by passing a balanced budget law that requires the government to run near-zero structural deficits indefinitely.
The European fiscal compact, an inter-governmental treaty that came into effect in January, provides far less flexibility to countries as they try to meet their deficit-cutting targets than they had under previous agreements. Under the fiscal compact, Italy will be required to pay back debt worth more than 2 per cent of GDP each year. To achieve that goal, Italy will need to run very large structural surpluses for almost a generation.
So if you want austerity to end, you need to start by repealing the fiscal pact and amending some of the secondary legislation governing fiscal policy co-ordination. I do not think this is going to happen. My conclusion is that austerity is here to stay, but will simply be presented with warmer words.
And it will last for as long as the euro exists.
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