Draghi and austerity champion Italy

Why Italy is a cautionary tale for other eurozone countries and why we need to avoid repeating austerity mistakes after Corona

I wrote a column in Handelsblatt about why Italy’s experiences with fiscal consolidation before the Corona crisis are a cautionary tale for other Eurozone countries. In this post, I will provide a slightly adapted English translation including data and graphs.

The government of the new prime minister Mario Draghi as well as future Italian governments will have to find a sensible way in dealing with Italy's public finances. Given the impact of the crisis, Italy's fiscal deficit was more than 10% of GDP last year. Public debt rose to around 160% of GDP.

Why was Italian public debt so high even before Corona? It is mainly a legacy from the 1980s, when public debt soared in an environment of interest rate hikes.

Source: Macrohistory database; Eurostat.

Since then, however, Italy has been more “frugal“ than any other country: since the early 1990s, the Italian government has consistently run budget surpluses if interest payments are excluded. Nevertheless, the interest burden, high due to legacy debt from the 1980s, has repeatedly pushed the overall budget balance into the red. In the period leading up to the financial crisis, Italy implemented by far the most drastic budget cuts compared with all other industrialised countries.

Source: Devries et al. 2011

Italy's public debt to GDP ratio remained so remarkably high before Corona mainly because economic growth had been so weak in the preceding twenty years. Instead of reducing the government debt-to-GDP ratio, repeated government spending cuts for the purpose of deficit reduction contributed to the stagnation of the Italian economy. Thus, Italy has not been able to grow out of its public debt.

Source: AMECO.

Italy's experience is a cautionary tale: a one-sided focus on fiscal consolidation can produce negative macroeconomic effects and increased unemployment - and thus undermine debt sustainability. This lesson is supported by the experience of other Eurozone countries with negative effects of excessive fiscal consolidation policies during the Euro crisis.

France and Spain will have similarly high government debt ratios after the Corona crisis as Italy had before Corona. European policymakers must do their utmost to avoid driving these countries into a vicious cycle in which fiscal consolidation undermines economic recovery and thus the achievement of fiscal targets, leading to further consolidation requirements. If this is not avoided, the continued existence of the Euro will once again be at stake - with potentially negative domino effects for Germany and other member countries.

A sensible approach to public debt requires a departure from the mindset that only a strict general fiscal consolidation stance can ensure debt sustainability. More public investment is needed, which has fallen sharply as a result of austerity policies. The Italian economy must grow for the public debt to remain sustainable in the long term. Future governments - starting with Mario Draghi's - must think about this, as must the EU Commission.

Source: AMECO.