Wednesday, October 3, 2018

The Italian Debt/GDP ratio hysteria

The prospect of an Italian budget deficit of 2.4% of GDP has unleashed extraordinarily strong adverse comment by EU officials and politicians, from Draghi to Juncker, from Dombrovskys to Mattarella, to former ministers like Moscovici and Berlusconi (of all people!) who in their days in government have been among the worst offenders of EU austerity constraints: they actually claimed that the very existence of the Euro was under threat. They should have remained silent at least until greater details of the budget were unveiled, in order not to cause the market upset and rise in the spread between the yield on Italian and German bonds, that they ostensibly feared but in truth whipped up and welcomed with great enthusiasm.  They were aided and abetted by the media hysteria of Italian and European press and television; deputy premier Di Maio rightly spoke of “media terrorism”.

Concern was generally expressed about the sustainability of Italian debt, presumed to be reversing its recent course of slow but steady decline as a proportion of GDP. Yet the arithmetic of Debt/GDP ratio evolution over time is very simple and well known, and in no way justifies concerns for a budget deficit of 2.4%, nowhere near the sustainability limits. The point has been made only by Senator Alberto Bagnai, president of the 6th permanent Commission for Finances of the Italian Senate, in various posts on his blog, and is well worth a reminder.

The budget balance f* that stabilizes the debt/GDP ratio in year t is given by following relationship:
f* = d(t-1)*g/(1+g)
where d(t-1) is the debt/GDP ratio at the end of the previous year (t -1), and g is the nominal growth rate of GDP in period t. A budget balance lower than f* will necessarily involve a decline of the Debt/GDP ratio in the course of the same year t. This is not a controversial theory, nor rocket science or high mathematics, it is an incontrovertible relationship of simple arithmetic.

To calculate this critical magnitude of the budget balance that will stabilise the debt/GDP ratio in 2019, we need two values, both unknown in 2018 (i.e. today): the value of the debt/GDP ratio at end-year 2018, and the nominal growth rate in 2019. The IMF estimates that Italy’s Debt/GDP ratio at the end of 2018 will be 129.7% of GDP, while GDP nominal growth in 2019 would be 2.5%, made up of 1.13% growth, and about 1.4% inflation (IMF World Economic Outlook, April 2018). Subsequent updates lowered real growth by about one-tenth of a percent. Thus we can assume conservatively a 2019 real growth of 1% and 1.4% inflation, i.e. a nominal growth rate of 2.4%.

By the relationship mentioned above, the value of Deficit/GDP ratio f* sufficient to stabilize the Debt/GDP ratio is therefore:
f* = 1.297(0.024/1.024)=3.03%
(more precisely, 3.0398 i.e. almost 3.04%). The prospect of a 2.4% budget deficit amply satisfies this constraint, leaving considerable room for contingencies; as it happens, the 2.4% deficit target also happens to amply satisfy the Maastricht ceiling for the budget deficit (which no one proposed to violate). Indeed a deficit rise with respect to the level embodied in earlier growth estimates is bound to raise nominal growth as well above earlier estimates, something that Ministers Tria and Savona were quick to point out, but this is a minor additional argument in favour of current policies, with respect to the powerful implications of 2.4%<f*.

Loose and reckless talk is unbecoming of respectable officials and reporters. Regardless of whether it is due to incompetence or malice, it breeds distrust and contempt, though fortunately it also, in the end, raises popular support for the government.


BG said...

Great post, Moscovici is a such a joke!

D. Mario Nuti said...

Sure, why, can Juncker be taken seriously, the custodian of austerity who for twenty years presided over a gigantic fiscal paradise that robbed and is still robbing other countries of their fiscal revenue? And Salvini was quick to retort that he only spoke to sober persons. And Mattarella, interpreting “budgetary equilibrium” as a continuous zero deficit, which makes him complicit with previous government deficits which he approved? And Berlusconi, who recklessly dilapidated the fiscal space painfully constructed by Prodi and Padoa Schioppa, raising the spread to over 700 points and now talks of austerity? A band of jokers, tragically in charge.

Ponzi said...

I am willing to take on trust your economic considerations, but I would like to stress that the problem is political. The populist-sovereignist government has decided to play with fire with international credibility and responsibility, in search of facile consensus.

From this point of view they are the children of Berlusconi without the coating of liberalism: unrealistic promises, skilled use of new media, violent language against the institutions, charismatic leaders, an opaque party-company, manipulative talk of direct democracy, political use of xenophobia, contempt for cosmopolitanism (Europe) and for intellectuals and so on.

The difference between today's government and Berlusconi is that Salvini’s anti-liberal ideology and the 5Star confusion draw different scenarios. Obviously we live in a world different from the Berlusconi era, many things have changed quickly as a result of the global crisis.

I do not know if you like Putin and Trump, both are role models for our government. I think they are very dangerous models: the ideology of the opposition between "us" and "them," the fiction of a united people without differences in status, interests, classes (poor Marx!), economic nationalism against global plutocrats, are something that we have seen in Europe, before World War II and after. I'm not saying that history repeats itself, but we should have learned something in all the intervening time.

D. Mario Nuti said...

I was only talking about debt sustainability conditions. On the causes and meaning of growing populism my views are very different from yours, they are summarised in a recent lecture published last week by Social Europe in two instalments, and In brief, if the self-styled “Left” of Blair-Schroeder-Clinton had not been perverted by hyper-liberalism and had done its job of defending workers, instead of supporting unconditionally globalism, austerity and free movements of capital and labour in a world without borders, especially in Europe where the "Left" passively accepted German hegemony, populism would not have succeeded as it has done repeatedly and increasingly in the last few years.

Ponzi said...

I read your Warsaw lecture. I share your judgement on the inability of Blair and others to go to the heart of the German/European problem, but I feel you have been blinded by your anti-Blair fury (apart from Iraq).

A major and non-negotiable point of dissent: xenophobia is not a civil right, but only its negation: from the French Revolution onwards, civil rights are universal or they are not civil rights. Very simple.

By the way, you did not answer me on one point: are Putin and Lepen the rising stars of the sovereignist left?

D. Mario Nuti said...

Ponzi, I do not mind if you do not regard the right to fear as a civil right. But I am the only person who can decide whether I have or do not have fear, and nobody has the right to tell me whether I can or cannot have a fear of anything I chose to fear, rightly or wrongly, no matter how idiosyncratic.

Putin is a dictator and I do not particularly like him, but sanctions against Russia for having kept Crimea are ridiculous, especially in view of European involvement in the Maidan revolt in Kiev, of NATO’s enlargement to ex-Soviet states in spite of earlier commitments not to do it, as well as German failure to comply with EU sanctions when it suits them to buy large quantities of Russian gas and oil, as Trump recently pointed out to Merkel.

I abhor Lepen, but the Rassemblement National would not have had the success it had if the Left had done its job, instead of supporting an impopular, coward, corrupt and incompetent Holland. Similarly, I am not fond of Trump but he is the legitimate President of the United States and the Democrats should have known better than put forward an equally impopular, corrupt and incompetent candidate like Hilary Clinton.

Mario B. said...

Your and Bagnai’s algebra is correct, except that your f* should be defined not on an accrual basis but on a cash basis, i.e. including items already committed in previous years but not yet spent. On the basis of such “stock-flow adjustment”, mostly due to investments not yet realised, the deficit rises to 3.1%, which is too close for comfort to your Debt/GDP stability ceiling.

D. Mario Nuti said...

Well, this could be a problem, especially since this government is bound to try and reduce arrears owed to suppliers instead of keeping them at an illegally high level. But the assumption that the entire backlog of delayed investments will be liquidated in 2019 sounds as plausible or as implausible as the assumption that it will stay constant. Some considerable room for manoeuvre undoubtedly will remain.

Mike M. said...

Amazing that szimple arithmetic escapes the deficit hawcks...

D. Mario Nuti said...

There's none so deaf as those who do not want to hear...

V.T. said...

Your arithmetic is impeccable but the problem remains that Italian public debt is still very high, and far above the 60 percent of the Maastricht rules. That level makes it a potential threat to both the Italian economy and Italian society. Furthermore, it makes it a disincentive to investment.

Total public spending in Italy remains close to 50 percent of GDP, in spite of the sharp fall in nominal interest rates over the years. It is 10% of GDP above that of the G7 or the G20 countries. It is even higher than Sweden's!.Given that level, how can you believe that more public spending is what is needed now, and that more spending, as the government intends to make, would make the economy grow?

D. Mario Nuti said...

There is spare capacity and large unemployment, there is no inflationary threat anywhere in sight. Of course some restraint is desirable, pity that former governments wasted the fiscal space created at great costs by Prodi and Padoa Schioppa. But one of the factors containing the French debt was precisely their lesser enthusiasm for austerity compared with Italy’s cuts implemented by Monti, Letta, Renzi and Gentiloni.

It is preferable to be disciplined by markets than by mysterious magic rules, the worst predicament is having to face both the discipline of the spread and the EU and EMU silly rules.

Fred said...

If the new government really meant to change course, they should have put additional funds in public investment, reduce social security charges on new employees on contracts of indefinite duration especially the young, and leave retirement age unchanged restoring pension entlements only for the "esodati"(who were defrauded by Fornero into taking early retirement thereby losing both work and pensions when retirement age was raised).

Balls said...

And while they were at it, they should have allowed those entitled to the new "citizen income" to spend it as they wished, instead of trying to restrict it to "ethical" purposes in a nanny-state fashion, except perhaps for tobacco and gambling.

D. Mario Nuti said...

I quite agree with both Fred and Balls.

Alberto Chilosi said...

"a deficit rise with respect to the level embodied in earlier growth estimates is bound to raise nominal growth"

Not so easy, much depends on the consequences on growth (as well as on the public expenditure on the service of debt) of the ensuing rise of interest rates.

"as it happens, the 2.4% deficit target also happens to amply satisfy the Maastricht ceiling for the budget deficit (which no one proposed to violate)"

First of all the increase in the deficit target is a declaration of a line of policy (as underlined by Di Maio jubilant performance on the balcony). The 2.4% depends on questionable assumptions that can lead to a much higher target, and on the declared willingness of the partners (Di Maio in particular) to pursue their clientelistic demagogic policies (such as going back from the Fornero pension reform), without being conditioned by the financial markets. Somebody should explain to Di Maio that the only source of funds for financing the deficit is the willingness of financial market to purchase the additional issues of state bonds at some sustainable interest rate. I would expect that it is the jubilant balcony performance of Di Maio rather than what Juncker or Moscovici may have said that has spooked the market leading to the increase of the spread (and indeed the spread increased suddenly after the decision to increase the deficit, much before any talk by them). As to to the Maastricht criterion of 3% this refers to the deficit if the debt is at the required level or if it is decreasing adequately if it is higher.

Alberto Chilosi said...

"sanctions against Russia for having kept Crimea" not kept Crimea, but occupied and annexed Crimea against international law and the 1994 treaty on the Ukrainian integrity; "European involvement": besides the political involvement of the West there was a quite massive political involvement of Russia (If I well remember Putin at a certain moment went even openly to the Ukrainian television to support the candidature of Yanukovic); in particular on a massive scale against the democratic decision of Ukraine, as an independent country under Yanukovic presidency, to strike an association treaty with the Eu, which led to the so called Maidan revolt after Yanukovic was cowed by Putin not to sign.

Alberto Chilosi said...

The point is that the financial systems of the component states of the EU are deeply intertwined. A bankruptcy of one would have deep negative consequences on the other ones, so an option of benign neglect is not tenable. I was wandering why it is not so in the USA, where the insolvency of local authorities and even of states is of no concern of the Federal authorities and even less of the Federal Reserve. I found the answer in the statistics available at
the average debt of American states is 5.1% of their GDP. The most indebted state is Rhode Island, 14.67% of GDP.
Of course they have a Federal Budget and a Federal Debt. And, in particular because of the automatic stabilizers, the American Union is a transfer union. Contrary to what often one hears also the European Union is a transfer union (the poorer states and regions gain at the expense of the richer), but only to the level of 1.5% or so of the European GDP. And it seems there is no much willingness around to go further.

D. Mario Nuti said...

Thanks Alberto, I have been away for a few days and I only just saw your comments.

On your last point, the fact that Italy is Too Big To Fail and the danger of contagion should induce officials in Brussels and Frankfurt to be more cautious in whipping up trouble for Italy just because they do not like its new government.

Alberto Chilosi said...

It is not matter of like or don't like. The too big to fail argument is not enough to allow Italy to pursue any reckless unhinged policies its populist government wishes to pursue. Eventually Italy's financing of its deficit will depend not on Brussels but on markets. There is a lot to spook markets besides Brussels' commentaries. If eventually the spread will be unsustainable and Italy will be on the verge of financial collaps the help that EU (or the IMF) may extent will be strictly conditioned as it was in the case of Greece. In May the foreign-owned share of the Italian debt was about a third, in the meantime it has certainly decreased, as well as the 6% owned at the time by Italian private citizens (the capital flight continues, as is shown by the Target2 figures). The bulk of the debt is owned by Italian financial institutions (banks, pension funds, the Postal Service), not by foreign European banks as in the case of Greece, and not even by Italian citizens as it was long ago (57% in 1988). A bailout of Italy then would be possibly less consequential than at the time the bailout of Greece. In case of default the greatest casualty will be Italy and the living standards of Italian citizens. Therefore I would be not too much impressed by the too big to fail argument. The latter seems to me a bit alike the too big economy not to have an agreement with in the case of UK brexiteers, and Liam Fox contention that the agreement with the EU would have been "the easiest in human history" to have.

Unknown said...

Hello Professor,

How much I hope everybody could read your post.

Reckless Talking nowadays is being used as a non conventional policy, it is basically "forward guidance" as the ECB and the Bank of England called it, only on a negative and "terroristic sense".

It is really incredible how even "grown-up" economists would forget the flow-stock relationship between deficit and debt and how calcuation of the deficit threshold under which the debt/GDP ratio would keep its downward trend has been basically never mentioned in the news.

On top of this, the 3% limit has also been forgotten (we are well below that, whatever the case), some say because the debt/GDP target has priority, some others because of your point on "media terrorism".

We should also mention that the plan for deficit has been revised in Spain, going from a projected 1.4 to 1.8, and that France has been enjoying quite some freedom in terms of deficit for quite some time (around 2.4 - 2.6 percent this year, perhaps?)



D. Mario Nuti said...

Bloomberg Opinion columnist Ashoka Mody (Princeton) recognises that the Italian budget "is not as crazy as it seems: His text (25 October) slightly shortened is reproduced below, for Alberto's reassurance and Nicola's support, with my thanks for their comments.

Europe’s leaders have come down hard on Italy for its plans to increase spending with the aim of boosting growth and helping the poor. What they fail to recognize is that a little stimulus might be just what the Italian economy needs.

The outlook for the global economy is deteriorating more rapidly than forecasters realize. A slowdown in China has hit global trade, European exports are decelerating, and euro-area business sentiment is sharply down. All this can’t help but affect Italy, where industrial production is barely increasing and a recession may be imminent.

This is the context in which one should judge the increasingly strident debate between Brussels and Rome. The new Italian government, led by the right-wing League and the anti-establishment Five-Star Movement, proposed a fiscal stimulus that would cause the budget deficit to rise to 2.4 percent of gross domestic product next year. The European Commission rejected the plan as irresponsible, sparking a showdown that has included an episode of shoe-banging in the European Parliament and a crude exchange of words on Twitter. Amid the discord, the yield on Italy’s 10-year bonds has kept rising.

Yet if the Italian economy is stalling, fiscal stimulus may be the only way to avoid a dangerous recession, which could tip Italy into an unmanageable crisis. Certainly, the EC’s insistence that the Italian government honor its predecessor’s commitment to shrink the budget deficit is completely unreasonable. Austerity will worsen the slump and, hence, increase the government’s debt burden (expressed as a percentage of GDP). This, in turn, will aggravate rather than ease market tensions.
As regards how to spend the money, the traditional recommendation — that it should go toward infrastructure or other long-lasting investment — might not be an immediate priority. ... Financial support for low-income families, ..., could be particularly effective, because the money would go to the people most likely to spend it.

The war of words between the EC and the Italian government leads nowhere. In principle, the commission can impose financial penalties if Italy ignores its recommendations, but even German Chancellor Angela Merkel has recognized that doing so serves only to “bring about insolvency particularly fast.” In any case, such fines are a political non-starter: The heads of government who comprise the European Council, which must authorize any action, will not impose sanctions for fear that their own countries could be sanctioned in the future.

The government’s vague and erratic policies have caused consternation in markets. That said, EC officials’ harsh pronouncements on Italy have also pushed up borrowing costs. Some may see this as a useful source of pressure to keep Italy in line, but it’s playing with fire in a tinderbox. Rising yields and falling bond prices put added stress on already fragile Italian banks, which hold large quantities of government bonds. Distress among banks, in turn, can necessitate bailouts that further worsen the government’s finances. A slowdown in the broader economy will only worsen this dynamic, pushing the weak banks and government finances into a vicious downward spiral.

In such a perilous environment, failure to pursue a constructive discussion could precipitate economic and political disaster. On the other hand, changing the narrative to give legitimacy to a modest Italian stimulus will reassure investors and calm the markets. European officials should quickly reconsider their position.