Some thirty years ago, the American economist Charles Schultze (former chair of the Council of Economic Advisers and director of the Budget Bureau) addressed a question in reference to the U.S. budget deficit in terms of a metaphor: Is it a wolf at the door, a domestic pussycat, or termites in the basement? In retrospect, the question, raised at a time when the ratio of U.S. general government debt to economic output stood at less than 60 per cent, seems rather trivial in the light of a debt ratio nearly twice as high today and rising. At present, the question is highly relevant, as fiscal sustainability has become an issue under discussion in many countries, following the jump in public debt since the financial crisis.
Broadly speaking, in the majority of G7 economies, public indebtedness can be regarded as a pussycat ensconced on a sofa in the living room, as long as governments are committed to containing the debt ratio with prudent fiscal policies, in some cases under the constraint of budgetary rules. But in Italy, Japan, and United States, with public sector liabilities in excess of GDP, the fiscal sustainability problem will not vanish in the period ahead. In these countries, where governments have little or no appetite to adopt policy measures to reduce the debt ratio, the outlook for public finances is akin to termites that over time can erode the foundation of a house.
As documented in empirical studies, high and rising indebtedness tends to depress economic growth. Also, beyond a certain level of public debt, financial crises become more likely and severe. Unchecked borrowing needs of the public sector are typically met with private saving, at the cost crowding out productive investment. This can be alleviated with central bank financing of budget deficits, leading to inflationary pressures and exchange rate depreciation to be compensated with a risk premium for government bondholders. To prevent this process from getting out of hand, the authorities cannot postpone indefinitely a fiscal adjustment. Yet such a scenario is not likely to materialize in the United States or Japan any time soon, the growth- dampening effect notwithstanding.
Italy, however, stands apart from these cases in three worrisome respects. First, as a member of the euro area, Italy operates in fact under a fixed exchange rate, as monetary policy is controlled by the European Central Bank. Thus, with a public debt ratio currently at 132 per cent (about one third owned by nonresidents), Italy is vulnerable to shifts in the sentiment of bondholders who are prone to divest from government paper when sensing a rise in risk – as witnessed during the recent political stalemate. On present policies, vulnerability is bound to deteriorate over time. If we include the net present value of future implicit pension and health-care liabilities (even ignoring the effect of population aging) public sector debt is estimated to be around 170 per cent of GDP.
Second, Italian financial institutions have become major sovereign bondholders in the aftermath of the euro debt crisis. In principle, banks can act as a shock absorber to at least alleviate a shift in market sentiment. But, given their fragile condition (evidenced by sizable nonperforming loans), a spike in sovereign risk premium, as experienced a few weeks ago, would further damage bank balance sheets, calculated at market value. In the event, we would see a repeat of the bank-sovereign doom loop that was endemic during the euro financial crisis, spreading rapidly across Europe and beyond.
Third, so far, the new coalition government does not augur well for completing much-needed structural reforms in number of areas – labor market practices, banking regulation, public administration, and the judiciary system – which, through contribution to higher growth and debt reduction, would restore fiscal sustainability. On the contrary, electoral promises by the coalition partners – including reversal of public pension reform and repudiation of EU fiscal rules – if followed through and implemented, will surely accelerate the debt spiral and doom the economy to continued stagnation.
Arguably, Italy faces a possible shift from a “good” to a “bad” equilibrium, comparable to the so-called multiple-equilibrium crises experienced in recent years by Greece, Portugal and Ireland. In those crisis episodes, an extraneous event precipitated a sudden stop in capital inflows, against the backdrop of the vulnerability stemming from massive public indebtedness that could not be managed under a fixed exchange rate regime. Likewise, in Italy, the termite infestation can easily snap into the wolf at the door if the current government threatens to abrogate the commitment to fiscal probity as an EU member and fails to address weaknesses underlying the erosion in competitiveness over past decades.
As the necessary condition for averting a full-fledged financial crisis, primary responsibility for undertaking corrective action lies with the Italian authorities. But, as a sufficient condition, it behooves the EU institutions to support such an effort with a debt redemption or restructuring facility for coping with the large legacy debt, coupled with tangible progress toward a euro-wide banking union. The alternative, namely, of ignoring these two conditions, will be catastrophic for Italy, with dire consequences for the euro area as a whole. The recent widening in sovereign bond spreads and dip in bank shares, not only in Italy, but elsewhere as well, serves as a mild foretaste of such an outcome.
Source: International Monetary Fund
* Based on remarks at the Workshop on Global Cooperation for Financial Stability, held at ISPI, Milan, April 9, 2018. The author is grateful for comments by workshop participants, but he alone is responsible for all opinions expressed.
1. See C. L. Schultze, “Of Wolves, Termites, and Pussycats: Why We Should Worry about the Budget Deficit” The Brookings Review (Summer 1898).
2. S. G. Cecchetti, M. Mohanty, and F. Zampolli “Achieving Growth Amid Fiscal Imbalances: The Real Effects of Debt” Achieving Maximum Long-Run Growth (A symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 25-27, 2011) found that, in OECD member countries, public debt ratio above 85 per cent reduces potential growth.
3. See C. Reinhart and K. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009).
4. See G. Kopits, “Managing the Euro-Area Debt Crisis” in L. Odor, ed., Rethinking Fiscal Policy after the Crisis (Cambridge University Press, 2017).
5. In the present circumstances, an example of such an extraneous event would be a synchronized stepped-up tightening of monetary stance by the Fed and the ECB - in terms of more aggressive interest rate hikes and withdrawal of quantitative easing.