Italy is the right place in which to assess how the new Stability and Growth Pact (SGP) works. This new set of rules for the conduct of fiscal policy in the euro area was established in March 2005, when the Ecofin approved a revision of the earlier Pact after France, Germany and Italy in 2003 and 2004 had rejected the “excessive deficit procedure” recommended by the Commission. Though the revision confirmed the limit of 3% deficit/GDP ratio as the pillar of the procedure, some of the many criticisms levelled against the original version of the SGP were recognized, so that
· the approach to excess deficits was rebalanced from the “static”, year-by-year, measurement of the deficit-GDP ratio towards a “dynamic” control of public finances and debt sustainability (or sustained public debt consolidation for high-debt countries) through multi-year fiscal plans
· some more “flexibility” was injected by allowing the deduction of a list of long-run growth-promoting expenses
· a longer time span for the correction of excess deficits was granted
· a less stringent definition of “recession” was introduced for a country to qualify for exemption from the excess deficit procedure.
Will these innovations be enough to render the SGP a viable framework for fiscal policy in the euro area? From the technical point of view, the new SGP is moving in the right direction, first and foremost thanks to the change from the “static” to the “dynamic” approach to the assessment of fiscal stances, and the redefinition of “bad times” to qualify for exemption from the 3% ceiling. The previous exemption clauses were based on the increasing “gravity of recessions”. All of them included negative GDP growth rates (from less than -0.75% (“mild”) to more than -2% (“exceptional)). To the negative growth rate criterion the new exemption clauses add that of “growth gap“, this being a growth rate that, albeit positive, falls short of the potential rate. Thus, a growing country may well apply for a relaxation of the 3% ceiling if its government shows that the actual growth is less than what it should be. This seemingly small technical change may have substantial implications. Figure 1 exemplifies that from 2001 to 2006 France, Italy and Germany indeed underwent a sequence of severe growth gaps.
Figure 1. Output growth gaps in the euro area, 2001-2006
Source: Elaborations on Ameco database
Assessment of the new SGP at the political level is far more difficult. After the 2003 showdown, the three major culprits all strove to bring their accounts back below the 3% threshold. Yet tensions with the Commission about fiscal policy are still there. As far as Italy is concerned, table 1 reports main macroeconomic and fiscal indicators from 2001 to 2007, whereas table 2 reproduces the SGP plan approved by the government as of September 2007. In spite of the improvement in macroeconomic performance, the conspicuous fiscal adjustment, a halt in debt growth, and the approval of the subsequent consolidation plan, the relationships between the Italian government (notably a pro-Europe government) and the Commission are far from being cordial.
Perhaps the most telling expression used by the Commission (and probably the most irritating one for the Italian government) is that fiscal consolidation is “not ambitious” enough. Italy is a high-debt country with historically loose control over public finances. The new SGP stress on debt consolidation legitimates the Commission to urge Italy to be “ambitious” on this front. However, the government has objected that Italy’s SGP plan approved in 2006 established 2.8% for the deficit/GDP ratio in 2007, whereas the ratio is now expected to reach 2.4%. Further, thanks to a large primary surplus, the debt/GDP ratio is actually falling again. This notwithstanding, the Commission’s judgment arises from two specific issues: the (mis)use of the extra-revenue (“tesoretto”) of 2007, and hence the speed of fiscal adjustment towards the balanced budget that is now due to arrive in 2011. In short, the Commission’s view seems to be that, since Italy is now in good times, fiscal consolidation should proceed much faster by allotting the whole extra-revenue of 2007 to this aim. By contrast, the government has roughly split the extra-revenue into three slices: one for fiscal consolidation, one for tax cuts, one for social expenditure. This, in the government’s view, fairly reflects the (estimated) sources of the extra-revenue: one third from cyclical recovery, and two thirds from structural reduction of tax evasion that the government has promised to use “to the benefit of honest taxpayers”.
A first “technical” question in this quarrel relates to the interpretation of the new SGP. To put it very simply: are good times really good? Here I do not wish to address the problem of how the Commission measures the so-called “cyclically-adjusted” vs. “structural” public budget (a controversial issue, to say the least). I only note that the Commission seems to make no reference to the new concept of growth gap. The available data suggest that Italy, as well as the other major euro economies, are still far from reversing the sizeable growth gaps that they suffered in the past five years. As simple macro-fiscal accounting shows, if a country is on a fiscal consolidation path, growth gaps do reduce the speed of adjustment of fiscal variables. Moreover, since the fiscal deficit accelerates while the GDP decelerates, the worsening of the deficit/GDP ratio is amplified beyond the government’s direct responsibility. Thus, asking a country to speed-up fiscal consolidation while growth gaps are not yet positive is tantamount to imposing a restrictive fiscal policy in bad times. In a joint work with Edoardo Gaffeo and Giuliana Passamani, we have tried to quantify these dynamic spill-overs between GDP growth gaps and fiscal variables by means of an estimated structural model of Italy (vis-à-vis Germany). We have found that:
· in Italy, excluding discretionary fiscal measures, the elasticity of fiscal variables to growth gaps is particularly high: starting on a balanced trend, a -1% growth gap has an impact of -1.74% on the total budget (-0.95% in Germany), hence the deterioration of the deficit/GDP ratio, which is roughly the algebraic sum of the two rates of change, gets close to 3%; in practice, the room of manoeuvre for fiscal stabilization is almost swallowed up in one shot even starting from a balanced budget
· eventually, even a temporary negative growth gap, if it is not offset by a positive one (the growth rate falls for just one year and then goes back on trend), leaves permanent gaps in levels: in our simulation, after all macroeconomic adjustments have taken place, Italy ends up with an output gap (in levels) of about -1% and a fiscal deficit of about 3% of GDP.
Therefore, it is not so clear that Italy is really in good times, that the slow speed of adjustment of fiscal accounts is to be put down entirely to the government’s bad will rather than to the slow-growth cyclical position of the economy, and that a faster fiscal consolidation now might not backlash on growth.
As is typical in European affairs, however, technical issues are closely intertwined with political ones. Supporters of the 3% deficit ceiling in the SGP claim that it is simple, transparent, easily communicable. No surprise, then, that public opinion can hardly understand what is wrong with a 2.4% deficit, especially after a tough budget correction in one single year. It is doubtful that raising the hurdle ex post is good pedagogy for endorsement of credible fiscal rules.
In a more general institutional perspective, it is also legitimate to ask to what extent issues such as the speed of fiscal consolidation, the allocational choices of fiscal revenue, the tax-expenditure mix, the aims and “ambitions” of fiscal policy and other matters that go beyond the numbers of the SGP lie within the boundaries that the Pact assigns to the Commission. Nowhere else in the world do technocratic structures enjoy independence from, or can exert tutorship on, democratic political actors as in the EMU. For this reason, even if these techno-structures possessed the right diagnoses and recipes for a country’s ills (and this may well be the case with Italy), they cannot also put themselves forward as active actors in the arena of domestic policy questions. The rejection of the constitutional draft was a loud warning that the so-called “democratic deficit” is a major stumbling block in Europe’s way. As argued by Charles Wyplosz, “using Europe as an instrument to solve purely domestic issues directly is unlikely to be a solution. It pits electorates against Europe, portrayed as a benevolent dictator. The problem is that benevolent dictators are not necessarily popular; externally imposed fiscal discipline puts the European integration process in jeopardy” (p. 221). Reforming national fiscal institutions and policies is a problem that should find a solution in each country’s own forces.
7 Responses to “The new Stability and Growth Pact: A view from Italy”
This a very interesting piece of analysis. Those criteria have to be though thoroughly by serious researchers. I have to admit that I have not read the Gaffeo et al. paper yet. But what, in your opinion would be a ”fair” way to think about the Deficit/GDP criteria? Thank you.
An excellent discussion. It is clear the Italy should do more fiscal adjustemt. But can this or any other relatively weak coalition governmentt achieve that?
I fully agree with your argument that fiscal policy at least should be left to national governments to use as stabilization tool since monetary policy is unavailable. What would be a productive deployment of the “tesoretto” in your opinion?
Dear Guest 2007-11-02:In my article I have written that the new SGP is moving in the right direction as it now takes more seriously the aim of combining “rigour” and “flexibility” whereas the second item was notably lacking in the former version. However, I subscribe to the view shared by many economists that the basic misconception in the SGP lies in the principle of a fixed ceiling for the deficit/GDP ratio. As has been argued times and again, there are no serious economic foundations for such a “magic number” nor are there clear connections between a fixed deficit/GDP ceiling, the correct management of public finances over the cycle, and the long-run goal of sustainable public debt (which by the way is the truly important goal in a monetary union). To put it very simply, the well-known problem that “one size does not fit all” strikes once more. It is intuitive, as also confirmed by our estimates, that the response of public finances to slow growth cycles (which raise a different problem than the cycle adjustment of the budget used by the Commission) may be different in different countries. Since the EMU countries already have a one-size monetary suite for all, it is not recommendable that they are also forced to have a one-size fiscal straitjacket. The mundane argument in favour of the 3% ceiling that it is simple, transparent, etc. is not suffient to rebalance its serious flaws. In fact, these alleged qualities have proved unable to shelter the SGP at its first important political test. As long as the EMU will lack a common fiscal governance comparable to the ECB on the monetary side, in my view there is no serious alternative to country-by-country negotiations with the Commission concerning sustainable fiscal plans that take into accurate account the specific structural and cyclical conditions of each country hopefully vis-à-vis the macroeconomic scenario of the EMU as a whole. Techincally, this is not a mission impossible, and, as I said, the new SGP is heading to that direction. The next step will have to be the breach of the 3% taboo. The political objection that countries in thge same community would be treated differently does not consider that treating equally different subjects violates the principle of vertical equity.
Dear Guest 2007-11-03, and BJ:I reply to your comments jointly since they basically raise the same question: What does Italy should actually do? Very briefly my view is that Italy faces two major challenges. The first is to keep the debt/GDP ratio on a “growth-cycle adjusted” declining path (and this should also suffice for the SGP). The second is to devise a more pro-equity and pro-growht mix between spending and taxing (but this is not the Commission’s business). Let me add that our post-SGP experience shows that the second task is more difficult than the first. Both taxes and expenditures seem “rigid downwards” in Italy. Fiscal consolidations have typically been realized more by raising taxes than by cutting improductive expenditures. Countercyclical or even equity policies have been pursued by spending more than by taxing less. Results have been, on average, dismal both for equity and growth. Further, my answer to the question about the ability of the center-left coalition in power to win these challenges is that the problem does not seem related to the colour of the government. The center-right coalition failed on the whole front even worse. So the bug may lie not in the colour but in the way coalitions are formed in Italy. In fact, political scientists think that structural problems in fiscal policy are often to be traced back to bad institutional design (governance rules, electoral system, etc.) This is certainly a major explanatory variable for the kind of fiscal problems that Italy faces.