Thursday, September 29, 2011

Moral Judgment and Bad Economics from the ECB

It seems that the ECB's policy prescriptions are being guided more by ideology and moral judgment than by sound economics. A very revealing letter from the ECB to the Italian government from August has just been published in the Italian press. The BBC reports:
ECB told Italy to make budget cuts

The European Central Bank told Italy to make sweeping changes to its labour laws and take tough action to cut the deficit, a leaked letter has shown. In the letter, sent to prime minister Silvio Berlusconi in August, the ECB said the severity of Italy's economic situation made "bold and immediate" action "essential".

...In unusually clear language, the signatories told Mr Berlusconi to make deep reforms, including opening up public services and overhauling pay bargaining and hiring and firing rules.

...The letter, published in Corriere della Sera, said Italy should aim to bring the deficit down to 1% of gross domestic product by 2012 and balance the budget by 2013, a year ahead of schedule, "mainly via expenditure cuts".
This is troubling in several ways. First, as the article points out, the timing of things certainly makes it appear as if there was a quid pro quo: the ECB would help only if the Italian government took certain policy steps that the ECB wanted. The ECB has continuously denied that there was any such condition attached to ECB assistance, however -- which is a relief, because otherwise this would look awfully like an instance where a central bank was blackmailing a democratically elected government.

Second, the ECB was apparently expressing a purely ideological preference for Italy to reduce its budget deficit through spending cuts. But shouldn't the size of a country's government, and decisions about whether to use tax increases or spending cuts to reduce a deficit, be determined by the country's democratic process? When Alan Greenspan disguised his opinion that the US budget deficit should be primarily reduced through spending cuts rather than tax increases as the official advice of the Federal Reserve back in 2005, many (including me) where dismayed by this conflation of economic policy advice with ideological preference. (Bernanke has done a much better job of keeping those two separate, by contrast.) So it's disturbing to find the ECB leadership now directly trying to impose its own apparent small-government inclination on democracies in the eurozone.

But third and most distressing to me is how a central element of the policy prescription that the ECB made to Italy was completely wrong. Italy's problem is not annual budget deficits; yes, Italy had chronically large budget deficits during the decades leading up to euro adoption in 1999, but Italy actually ran smaller budget deficits than France, Belgium, or even the Netherlands over the past couple of years (see chart below).

Italy's problem right now is low growth, and the fact that such low growth makes it more difficult for Italy to service the massive debt is has left over from 20 or 30 years ago. The recession hit Italy very hard, and the country has been slow to recover (which makes Italy's relatively low budget deficits even more impressive, by the way). The last thing Italy needs at this point is a sharp fiscal contraction.

So why would the ECB have asked Italy's government to apply contractionary policy when Italy is struggling to emerge from a very deep recession? Why would they point the finger at Italy's budget deficits as the problem, when Italy has been better than many of the core euro countries at keeping them under control? The economics of this policy advice is all wrong.

I fear that this is yet another sign of how the eurozone crisis has undammed a reservoir of cultural and moral judgment of southern Europe by some in the north. The north-south cultural divide in Europe has always been significant, but it was easy to overlook during the prosperous years leading up to the recession of 2008. Now, it seems, all of those old prejudices are coming out again, and a surprisingly large number of people are falling back on the simplistic sterotypes that southern Europeans are lazy and irresponsible, have jeapordized the euro through their moral failings, and need to be given a punishingly large dose of austerity - whether it makes economic sense or not. Unfortunately, it's beginning to seem like some at the ECB agree.

Martin Wolf and Paul Krugman eloquently point out that morality-based policy has triumphed over economics-based policy much more widely than just in this specific example.


  1. jesse3:35 PM

    Italy, as Germany, is made of a whole bunch of different regions. This is more about jingoist vote pandering, political history, and hubris.

  2. Dompac4:14 PM

    It't kind of ironic to read this and watch the stock market shoar up and up these past couple of days . . .how's that jingo go:" happy days are here again"

  3. Serious Sam2:35 AM

    Italy needs most of all a redesign of the partially overprotected job system. Which very efficiently keeps young people out of work. There are reasons why ever more italian people in their 30ies and even 40ies are still staying with their parents.

    And of course, Italy, like the rest of the GIPSIs, must reach a positive trade balance, otherwise the debt will never become manageable.

  4. Murdo McSponge7:36 AM

    Excelellent article. To quote William Topaz McGonagal "We're all doomed."

  5. PPP Lusofonia9:27 AM

    The ECB is following the inappropriate IMF recipe.  Privatization is seen as a cure-all, instead of focusing on the loose lending practices that allows inefficient public services to survive, as we've seen with the rising liabilities of deficit-prone State-owned company 

    Actually, the ECB should be more concerned with the funding costs disparities of European banks, and the failure of prudential regulation among the various national central banks which allowed excessive credit growth. 

    See Excessive SOE debt coming home to roost

  6. Random Lurker9:44 AM

    As an italian, I can tell you that the italian government has been very explicit, when defending umpopular "anti-crisis" measures, that those measures were requested from "europe" (meaning the ECB).

    @<span>Serious Sam</span><span></span>
    Italy job system isn't "overprotected" anymore, since at least 15 years, because of new kinds of contracts that effectively "dodge" the varius protections that were developed up to the seventies by unions.
    However, many workers, who got their job before those new contract laws came into effect, still enjoy older protections, thus giving some truth to the idea that italian workers are well protected.
    But this is only true for older workers, youngers italians have much more "flexible" (ie: sucky) contracts.

  7. penruddock11:33 AM

    Good article, and you are quite correct about the cultural prejudice whereby Europeans north of the Alps tend to see the Mediterranean peoples as lazy, feckless, untrustworthy, and irresponsible - characteristics that are the very opposite of those that allegedly typify the "frugal", "hard-working" and "respectable" northerners. I'm sure that Mr Trichet and his chums didn't have this contrast specifically in mind when they wrote to Mr B, but cultural prejudices undoubtedly form part of the context of the fraught discourses that are at present going on in the eurozone.

    On another aspect, in writing its letter to Berlusconi, the ECB was very clearly in breach of the terms of the Treaty of Lisbon, which require the bank to keep to a strictly non-political role. But then the Treaty these days is broken almost every day in one form or another. Better to scrap it, perhaps, and replace it with something else.

  8. ralfi6:21 PM

    imho, lower Gov intervention in italy would lead to higher long term growth
    (cutting subsidies, red tape, overall intervention in the economy, reducing civil servant's costs wages, cars, and credit card bills ...  will all be very good for italy in the (not so) long term.

    donno how it really is in italy, but in spain that recipe would be 'a match run' for society overall

  9. Anonymous9:05 PM

    Morality based policy - we want our money back with interest. We will run your country because you owe it to us now.
    Economic based policy - using  euro policy to blow bubbles and over endebt you when they burst.
    Euro policy  - central financial control of Euro governance.