Wednesday, November 02, 2011

Italy's Future

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.


  1. Javelin11:59 AM

    These numbers don't seem correct.  Just doing some quick back of the envelope calcs... so lets say Italy Debt is 130% of GDP.  Its duration is around 6.5 (not sure what it is but i know its fairly long) so lets say it needs to refinance 20% of its GDP next year plus whatever its deficit is.. 25% max.  250bps on that is only 0.625% more.  I don't see how you get from 2.6% to 5.8% just on increased borrowing costs.  I agree if it persists and Italy's borrowing costs are permanently elevated by 250bps, its on a death spiral but over a single year not sure how you arrive at these numbers 

  2. debitofilo4:11 PM

    you are right

  3. Kernow Castellan5:20 PM

    <span>"The ECB is the only institution that has such power right now"</span>

    Actually the ECB does not have this power, as it would require it to be a lender of last resort, This is expressly forbidden in its constitution (it has to go back to the 17 national central banks for that). Whilst it is the only body allowed to print Euro's, it is forbidden from doing so if it is in order to buy the government bonds of a Euro country.

    Madness, I know, but that is what the German's insisted upon. Even the small amount of reverse repos so far on Greek and Italian debt is actually ultra-vires and has had to be carefully dressed up in order to defeat the legal challenge in the German Federal courts.

  4. debitofilo5:32 PM

    well you can read the new report of new governor of bank of italy in page 15 16 there is a nice simulation

  5. debitofilo5:34 PM

    let me remember you that in italy there is a lot of evasion and 400 bln in fiscal paradise like switzerland and luxemburg this is a SHAME

  6. Dave Price1:26 PM

    "The only way to break out of this cycle is to do something radical to change market expectations"

    Magical thinking.  Italy's real problem is demographic.

    They are going to have to cut.  If borrowing rates rise, they need to cut more.  If that leads to contraction, they need to cut even more.

    Yes, it was very bad to get into a position where government is so large that cuts in gov't spending run the risk of becoming a death spiral, but this is what happens when the parasite and the host become too interdependent, and there is no magic wand to fix this.

  7. There isn't a primary deficit according to...Italian politicians.  There isn't a primary deficit assuming ... no European recession.

  8. Mathieu6:55 AM

    <span>If it's obvious for you, and now also for us, this must also be obvious for Sarkozy and Merkel (and their analysts). What is the (political) motivation for asking for spending cuts to Italy now now now then?</span>

  9. Mathieu7:11 AM

    <span>Just stating things does not make them true...</span>

  10. The demographics of Italy look better than those of Germany...

  11. In Hell's Kitchen12:34 PM

    Obviously, the banksters are flexing their muscle...they've got to recoup them MBS losses any way possible and who cares about the ordinary citizens.

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