Italy's Prime Minister, Silvio Berlusconi, is apparently going to propose some "shocking measures" in an attempt to get control of the downward spiral that the market for Italian government debt is currently experiencing. Most likely (thanks to the urging of Germany and France) these shocking measures will be composed primarily of sharp cuts in government spending.
This will fail to help. The market is not worried about Italian debt dynamics because of excessive government spending. It is not worried about Italian debt dynamics because of an excessive primary (i.e. excluding interest payments) budget deficit in Italy. It is worried about Italian debt dynamics simply and purely because of skyrocketing interest rate expenses that the Italian government is now facing thanks to the eurozone debt crisis.
In the table below I present three scenarios for the path of Italy's budget deficits and gross government debt (both as a % of GDP). Scenario 1 is the OECD's most recent forecast for 2012. To extend that baseline a bit, let's say that 2013 would look like 2012 in the absence of other changes. Note that the OECD's forecast is for Italy's debt/GDP ratio to remain roughly constant. Until very recently, there was no particular worry about the Italian debt burden getting out of hand. It is not at all obvious that under the baseline OECD forecast there is any particular urgency for Italy to reduce its budget deficit.
Scenario 2 illustrates why, even though the market is not worried about Italy's primary budget deficit (since Italy actually runs a primary surplus), it has good reason to be VERY worried about the recent rise in Italian borrowing costs. Suppose that in 2012 and 2013 Italy has to pay 250 basis points (i.e. 2.5%) higher interest rates than assumed in the OECD forecast. Suddenly Italian debt dynamics look very scary -- Italy's debt/GDP ratio, instead of remaining flat, will take off on a frighteningly familiar upward trajectory. (Hello Greece, here we come...)
Scenario 3 then supposes that the Italian government enacts dramatic cuts in government spending - let's say, cuts equal to 2% of GDP in both 2012 and 2013. Will that fix the problem?
The answer is clear: no. If anything, it will make the problem worse.
Cuts in government spending will be overwhelmed by Italy's higher borrowing costs, which are far, far greater in euro terms than any cuts in government spending that could realistically be acheived. And so Italy's budget deficit will still rise sharply. And if we assume that severe austerity will likely lead to a contraction in Italian GDP, as it has done in the UK, Greece, and elsewhere, then the trajectory of Italy's debt looks even worse with the cuts in government spending than it did without them. (I assume a government spending multiplier of 1.0 in this scenario.)
Austerity as a response to the recent rise in Italy's borrowing costs is exactly the wrong policy prescription. It misdirects attention from the real problem here, which is the self-fulfilling doom spiral in the debt market that Italy has gotten trapped in. The only way to break out of this cycle is to do something radical to change market expectations.
The ECB is the only institution that has such power right now. And yet it seems likely that they will sit on the sidelines, or even applaud Italy's austerity proposals -- the very proposals that are almost certain to make things worse rather than better.