Mario Monti looks poised to become the new Italian prime minister. In sharp contrast to what happened in the last days of Silvio Berlusconi, there will be a strong political desire in Berlin, Paris and Frankfurt to help him stabilise the Italian crisis, and the markets may bounce on this mood. However, the eventual outcome will be determined not by personal relationships at the top of politics, but by economic fundamentals and by the way in which they interact with much wider political forces. On these grounds, Mr Monti’s Italian job looks to be facing daunting odds.
There are three key factors which will determine the eventual outcome:
1. The Stabilisation of Public Debt
Italy’s predicted budget deficit in 2011 will be only 4 per cent of GDP, which translates into a primary (non interest) surplus of around 0.5 per cent of GDP. So what is the problem? The problem is that, as a legacy from the early 1990s, the public debt/GDP ratio is very high, at 120 per cent, which means that the sustainability of Italian public finances is very vulnerable to an increase in interest rates.
Any deterioration on this front does not have to happen quickly. The average duration of Italian public debt is about seven years, which is longer than many other major countries. It is true that 2012 happens to be a bumper year for Italian debt redemptions, which means that the sovereign will have to roll over as much as €350bn of debt, potentially at much higher interest rates than previously assumed. Even so, the impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with “normal” interest rates.
Markets, however, are forward looking, and they are in the mood to refrain from financing Italian debt rollovers if the public debt ratio is thought to be unsustainable. With medium term nominal GDP growth likely to be in the doldrums at 2 per cent per annum, interest rates at 6.5 per cent would mean that Italy needs to run a primary surplus of 5.5 per cent of GDP indefinitely in order to stabilise its debt/GDP ratio at 120 per cent. (See this calculator to try different assumptions.)
In order to break the vicious circle of debt and interest rates, the new government will probably have to embark on a credible plan to earn a primary budget surplus of over 5 per cent of GDP for several successive years at least. There is no doubt that a Monti government would announce such a plan, but the question is whether this could actually be implemented in the coming years.
I have examined the history of budget balances in advanced economies since 1980, and can really only find three comparable historic episodes of budget reform in which such large primary surpluses have been maintained for several years, and have led to large falls in debt ratios. These are Ireland (1988-2000); Belgium (1995-2007) and Italy itself (1995-2002). There are other episodes which are not comparable, because they are based on resource discoveries or unsustainable private sector booms.
In effect, Italy is being asked to repeat what it achieved from 1995 onwards, when it managed several successive years with primary budget surpluses above 3 per cent of GDP. But that was at a time when the economy was growing at a decent clip, quite unlike what will happen next year. If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least.
2. The Availability of Short Term Liquidity
Any package which provides liquidity to Italy needs to cover much or all of its refinancing needs for about three years. Otherwise it would not be credible. And a package which is not credible would unravel quickly, because even a small reduction in bond holdings by private investors would greatly add to the upward pressure on yields. To pick a round number, a credible package would need to make €750bn available to Italy between now and 2015.
Where could this money come from? At the moment, the only likely source is a combination of IMF and EFSF funds, which are then leveraged by borrowing from the ECB. This will strain the available resources of both the IMF and the EFSF, and could also run into problems with ECB orthodoxy (as we have seen from this interview by the head of the Bundesbank today). However, if there were a clear-cut guarantee given by an IMF/EFSF entity on all the Italian bond purchases ultimately financed by the ECB, it might be deemed in line with the ECB’s legal mandate. Without active ECB involvement, it looks like a tall order.
3. Improving Long Term Competitiveness
Italy’s labour cost competitiveness against Germany has deteriorated by around 50 per cent since the mid-1990s. How can this conceivably be reversed in a low inflation environment within EMU? The nation’s supply side problems are very deep seated, resulting from a complicated combination of history, politics and economics. The economy came 167th out of 179 countries in a league table of productivity growth in the last decade (according to The Economist). The list of measures which are essential to improve market flexibility and reduce the stifling role of the state would be a depressingly long one. And many of the most essential labour market reforms will certainly add to unemployment and deepen the recession in the short run, making the budget problem even more difficult.
Mario Monti is very well placed, through his previous experience as EU Competition Commissioner, to draw up just such a list of reforms. But implementing even a fraction of them during a recession and without a clear political mandate is, well, a challenging task.
Good luck to the new Prime Minister. He is certainly going to need it.
