Euro area reform: what should be the priorities for Italy?

February 21, 2018
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With elections only a couple of weeks ahead, the tendency to bash the euro (and Europe) seems to have greatly diminished among all parties.  But not bashing the euro and its rules is not enough.  Whatever government emerges after March it will have to take a stance on the reform of the euro area, which is already informally discussed intensely between France and Germany.

What should be the interest of Italy in this context?

The official government position usually been that the euro needs for a stronger safety net and a continuation of the expansionary policy of the ECB.  But why would Italy need this? It seems that the Italian government perceives itself as a debtor, who might one day need support from outside.  However, this view of Italy as a debtor country par excellence is not correct at the aggregate level.   The country is running at present a sizeable surplus on its current account; and if one looks further back one finds that external deficits and surpluses were of roughly similar size.  This means that the country as a whole is not a net debtor. Its net international investment position is roughly balanced, and improves thanks to the current account surplus. Italy cannot thus be compared to Greece which has run external deficits for over 20 years.  Italy is also in a better position than Spain and Portugal, which also run now current account surpluses, but still have a sizeable net foreign debt. Italy’s external position also appears stronger than that of France, which is running a current account deficit and has a sizeable negative net international investment position.

The solid external asset position of Italy has a number of consequences.

First, the country has little to fear from higher interest rates.  The government would have to pay more, but Italian citizens would earn more on their savings.  Mario Draghi might haves saved the euro in 2012, but Italy does not need his support any more.

A second corollary is that the country should be safe from speculative attacks as long as Italians themselves trust their own government.  It would matter little that speculators in London or New York sell Italian debt if the Italians themselves save more than needed to finance their own government.  This, in turn, means that Italy does not need a stronger safety net.

The strong external position is also the ultimate reason why the risk premium on Italian debt has barely moved during the recent bout of financial market volatility.  But the fact that financial markets are so ‘permissive’ also has its negative side.  Italy’s high public debt today is the result of successive governments preferring to spend, leaving the bills for others to pay later.  Most government have also paid lip service to the need to reduce the debt level.  But over the last quarter of a century the arguments has always been that ‘now is not a good time to have a balanced budget’.

A country with such weak fiscal institutions would actually benefit in the long run from tighter rules on fiscal policy.  Odysseus tied himself to the mast because he knew he would not be able to resist the chant of the sirens.  Italy would also gain if its political captains were prevented from running continuous deficits.  The opposition of the government, and large part of public opinion, against the Stability Pact and the debt reduction rule of the Fiscal Compact has thus little to do with the long term interest of the country.

Italy is becoming a creditor economy, but still has a problem with weak fiscal institutions.  It does not need a stronger safety net, but more effective limits on deficit spending.  It is a pity that whatever government will emerge after the elections is likely to take the opposite position.