While Rome burns, it’s time for some monetary and fiscal fiddling

Spain, Italy, Portugal and Greece face serious problems without EU-wide financial reform. AAP

Every year, on the evening of December 31, the President of the Republic of Italy addresses the Italian people with a video message broadcast by all the major radio and television networks. This “end of the year message” is traditionally an occasion for the president to wrap-up the main events of the year and to introduce citizens to the challenges ahead with optimism and confidence.

This year, President Giorgio Napolitano’s task is going to be particularly tough. The country is going through difficult economic times: its sovereign debt is under attack and a sharp recession is expected for 2012.

In the financial and economic turmoil, households have suffered financial losses and face growing uncertainty. Jobs are on the line, swinging markets threaten savings, and nobody is able to predict what course the crisis will take and how long it will last. All this certainly does not induce much optimism and confidence.

President Napolitano is playing a critical role in the crisis by providing strong personal and institutional backing to the technical government headed by Prime Minister Mario Monti. This government was formed in November to replace a politically exhausted executive headed by Silvio Berlusconi.

Berlusconi’s departure did not guarantee a resolution to the crisis. AAP

At the time, the technical government seemed to be the best possible option. Silvio Berlusconi no longer had the numbers in parliament and the international credibility to act against the speculative attack on Italy’s debt. No other government appeared to be viable and elections would have meant a prolonged campaign at a time when immediate action was required, not to mention the risk that the vote could have produced a new highly fragmented parliament still incapable of expressing a solid political majority.

A technical government had some appeal. Mario Monti is an internationally highly respected economist. His cabinet was formed by equally reputable technocrats. This should have addressed the credibility deficit that propelled the speculative attack. Furthermore, as a non-political figure, Monti was expected not to seek re-election, which in turn would have placed him in a unique position to undertake both tough austerity measures and pro-growth reforms.

So far, however, there has been relatively little improvement in the economic situation, at least according to the short-term indicators. The spread between the Italian and the German bonds has somewhat declined, but it is still high and the stock market remains very volatile.

For one thing, it would have been simplistic to expect that the departure of Berlusconi and the appointment of Monti would have been enough to address the structural weaknesses which are at the root of the Italian debt problem. One also has to recognise that up to now Monti’s government has been less effective than expected.

The austerity plan announced earlier in December mobilises quite a large amount of resources – estimates suggest a total of 30 billion euros. But, most of the measures concern an increase in taxation, including an increase in the value-added tax, which is likely to be highly regressive, rather than a cut in expenditures, as would have been more desirable.

Italian Prime Minister Mario Monti is yet to provide any long-term solutions to Italy’s crisis. AAP

Moreover, austerity should be part of a two-tier strategy, the second tier being the launch of a set of reforms to stimulate growth. Yet, these reforms are still under discussion and the timing of their approval, as well as their contents, remain quite ambiguous. In the absence of progress on reforms, the risk is that the austerity plan will be insufficient to overcome the crisis and will only make the recession worse.

As an archetype of the current difficulties in the Eurozone, the Italian situation offers the opportunity for a broader reflection on the crisis.

In particular, the events of the last months – and years – highlight two aspects on which the economics profession should probably elaborate a new perspective. One concerns the responsibilities of the “ordinary” people in causing the crisis and retarding its solution. The other is the need for a new paradigm of macroeconomic policy.

The responsibilities of “ordinary people” in the crisis

The ordinary people (that is, the general public of consumers, small savers and investors) blame speculative finance and inept politicians for the crisis. It would be easy to tell a story where the people are just the victims, ill-advised by banks and ill-assisted by governments. And to some extent this story would be true. But there is also another story, much more controversial and unpopular, which however needs to be told and metabolised.

The fiscal profligacy which caused excess debt in Italy and other European countries is the outcome of an intergenerational conflict where the “old” generation benefited from public overspending and transferred its cost on to the “new” generation.

Past governments might have tricked the old generation into believing that the Ponzi-game would be forever sustainable, but this old generation seemed to be only too willing to be deceived. In this perspective, the blame for the accumulation of debt should not just fall on short-sighted politicians, but also on equally short-sighted fathers who extracted the rents of public expenditure and passed the bill on to their sons.

Italy faces more civil unrest. AAP

But there is more. Now that fiscal stabilisation can no longer be postponed, each socioeconomic group or constituency in the economy would like its costs to be borne by the other groups and constituencies. The protests and demonstrations that accompany the announcement of austerity plans in Italy and other countries occur not because protesters do not recognise the need for austerity, but because they try to force the government to model the plan in such a way that “others” will pay for it.

In most countries, the political landscape is such that each group can have its interests and demands voiced by a representative political party. The distributive conflict between groups therefore translates into stalemate and inaction at the political level.

Under these circumstances, it becomes extremely difficult for a government to have an effective austerity plan approved and passed. In the case of Italy, the expectation was that the very technical nature of Monti’s executive would have allowed it to break the inaction arising from the cross-vetos of the various political parties. The reality instead has proved much more complicated.

Need for a new macroeconomic policy paradigm

Turning to the second aspect, the crisis has highlighted the weaknesses implicit in the existing macroeconomic policy paradigms. Monetary policy in the Eurozone follows a typically conservative model, where the European Central Bank is institutionally devoted to maintaining price stability.

In this context, the operation of monetary policy hardly takes into account any factor that is not directly related to the inflation target. That is, monetary policy is largely unresponsive to the business cycle.

This model has been so far successful in delivering low inflation. However, now that large-scale interventions would be needed to sustain the debt of countries like Italy and Spain, strict adherence to a conservative paradigm might end up endangering the objective of price stability itself.

Clearly, under the current institutional arrangements, the ECB cannot operate as lender of last resort for national governments. However, a more accommodative monetary policy stance would be beneficial in the long term, even at the cost of a marginal deviation of inflation from its target in the short-term.

A new monetary policy paradigm should probably allow the European Central Bank to deviate temporarily from the inflation target in response to union-wide (and not country-specific) shocks.

In a monetary union, the credibility and success of monetary policy depends on the stability of national fiscal stances. The European treaties try to achieve this objective through the imposition of fiscal rules and criteria that fix threshold levels for aggregate measures, such as the national deficit and debt-to-GDP ratio.

Monti has put his faith in tough austerity measures. AAP

The problem is that, once again, these criteria do not allow for any flexibility in the use of fiscal policy over the business cycle. In fact, they have determined the emergence of a paradigm where national fiscal policy is substantially a-cyclical, if not even pro-cyclical (and therefore highly destabilising).

As recent events indicate, the criteria have not been successful in consolidating the public finance positions of “riskier” countries – again, Italy above all.

In a situation where monetary policy is delegated to a conservative European central banker (who might eventually only respond to union-wide shocks), member states ought to be able to use fiscal policy in response to country-specific shocks.

This suggests two considerations for the future. First, the fiscal criteria should be redesigned. In particular, the limit on the deficit-to-GDP ratio should be referred to a cyclically adjusted measure of the budget balance and/or to a period average (say three or four years).

This would allow a country to respond to cyclical fluctuations in each year while forcing it to balance its budgetary position in the medium term. Hence, countries would no longer face a situation where they need to undertake sharp fiscal restrictions in times of recession.

Second, while a move towards greater fiscal integration in the union is desirable, as it would redress the unbalance between monetary and fiscal policy arrangements, idiosyncratic shocks might cause an unequal distribution of the costs and benefits of integration among member states.

A system of compensatory transfers would then be necessary. Its feasibility would however critically hinge on stronger political integration. And this is another story.