The EU’s dysfunctional fiscal rules empower the far right, both in Italy and elsewhere

PRIME’s co-director Jeremy Smith and Progressive Economy Forum Council member John Weeks analyse the “bar room budget-brawl” between the Italian government and the European Commission, and argue that the Commission’s wrong-footed response threatens to strengthen the far right – to avoid opening the door to fascism, the EU must ditch its bias towards austerity.

No one doubts that Italy’s economy is in a mess. It has been for a long time. It was not always so. From 1971 until 1992, income per capita increased on average by 2.7% per year. Among G7 countries this was second only to Japan, and ahead of Germany and France. Since then, the position has dramatically reversed – with a post-1992 average growth rate (also GDP per head) of just 0.4% per year.

Since 2000, broadly corresponding to the Euro era, real GDP per head has declined by 0.2% per year on average. And over the last decade, i.e. since the Global Financial and Euro zone crises from 2008, the decline has been severe, as this chart (comparing 10 “developed economies”) shows.

Unemployment exceeded 10% from early 2012 until very recently (latest figure, 9.7%). So something has to be done to get the economy moving.

In March of this year, a new coalition government was sworn in, composed of two non-establishment parties. The unlikely coalition consisted of the Lega, a far right nationalist party strong in the north, and the 5 Star Movement concentrated in the south. The latter has a rather eccentric, even muddled ideology, with some left of centre policies. Together, the parties scored around 50% of the votes cast, of which around 33% were for 5 Star. Seven months later in October, opinion polls show support for the coalition of around 60%, with La Lega (under its Alt-Right leader Salvini) leaping ahead to 31%, and 5 Star slipping back to 29%.

One of the less noticed and perhaps unexpected effects of the rise of right-wing “populist” governments across Europe has been that – alongside nasty anti-immigrant, socially conservative and authoritarian policies and rhetoric – their economic policies tend to be more geared towards protection of poorer citizens. By supporting austerity programmes and a dominant focus on “competitiveness”, European social democratic parties have failed to offer policies of economic protection to less well-off communities, and in Italy and elsewhere are paying the political price.

This is the backdrop to the latest very public “bar-room budget brawl” between the Italian government and the European Commission. It has quickly become clear that the Commission has demonstrated a lack of political wisdom by entering into this fight.

The European Treaties contain fiscal ‘rules’ that are contractionary – i.e. they tend to exacerbate economic downturns. Article 126 of the Treaty on the Functioning of the EU instructs member states to “avoid excessive government deficits”. The treaty requires the Commission to “examine compliance with budgetary discipline” in relation to two criteria: a deficit below 3%, and a government-debt-to-GDP ratio of less than 60%. For outcomes inconsistent with these levels, and not moving towards them “at a satisfactory pace”, the Commission is required to issue a report on non-compliance.

Not so much heeded, Article 126 requires the Commission to “also take into account whether the government deficit exceeds government investment expenditure”, as well as “the medium-term economic and budgetary position of the Member State.”

A labyrinthine set of EU legislative regulations buttresses these fiscal Treaty provisions, mainly developed in response to the Euro zone crisis. The effect has been to create an ever-more intrusive process of budget monitoring.

No penal process against Italy has yet been triggered under Article 126, nor is this likely in the near future. On 18th October, the Commission wrote to Italy’s Finance Minister

“to consult you on the reasons why Italy plans ‘an obvious significant deviation of the recommendations adopted by the Council under the Stability and Growth Pact’ for 2019, which is a source of serious concern for the European Commission.”

The main complaint is that the Italian government’s new budget for 2019 would increase the projected deficit to 2.4%, representing, according to the Commission, “a fiscal expansion of close to 1% of GDP, while the Council has recommended a fiscal adjustment” [i.e. cuts].  Both this proposed expansion, and the size of the deviation from the Council’s recommendations (around 1.5% of GDP), are “unprecedented in the history of the Stability and Growth Pact”, the Commission contends.

The Commission’s comparison is to the budget for 2019 proposed back in March this year by the outgoing centre-left government, which claimed that the deficit should fall from (estimated) 1.6% in 2018, to just 0.8% in 2019, and “a broadly balanced budgetary position by 2020”. The Commission recommended that an increase in government spending in 2019 should not exceed a minuscule 0.1%, an insignificant increase implying in real terms a significant cut.

With unemployment still projected to be above 9% in 2020, and an employment rate well below other major EU countries, it seems extraordinary that Italy should be required to reduce public spending, even if there are legitimate arguments around the actual content of that spending. One weakness that Italy shares with the UK is the low overall level of investment. Public investment is particularly low, at around 2% of GDP. But if one assumes it to be reasonable to borrow for investment, then of the new proposed deficit level of 2.4%, the majority relates in fact to capital investment.

The real concern for the Italian government is not the actual level of the deficit, but of the public debt, which is around 130% of GDP. Rogoff and Reinhart, two US economists, in 2010 implied (wrongly as later evidence showed) that debt levels in excess of a 90% of GDP threshold tend to depress growth and create financial instability. This view was enthusiastically taken up by the then Commissioner for Economic Affairs, Olli Rehn. But certainly, 130% is high, and if interest rates rise rapidly, this would add to the budgetary pressures on the Italian government.

However, unless there is a political fracas on this issue between the EU and Italian government, which would be unnecessary, no reason based on economic analysis presents itself as to why the debt to GDP level would rise more than marginally as the result of a deficit of 2.4% instead of 0.8%.

In our view, there is no merit in the argument that an Italian budget deficit in 2019 of 2.4% of GDP is wrong in principle or itself a danger to the Stability and Growth Pact, let alone to the Monetary Union. As recently as May, in its Spring 2018 European Economic Forecast, the Commission was forecasting this (page 97):

“In 2019, the headline deficit is set to remain constant at 1.7% of GDP, under the assumption of unchanged policies and excluding the legislated hike in VAT rates.”

On this as well as other assumptions,

“the debt-to-GDP ratio is expected to have peaked in 2017 at 131.8%… and to progressively decline to 130.7% in 2018 and 129.7% in 2019, mainly as a result of stronger nominal GDP growth”.

So the Italian government’s proposed deficit for 2019 is only 0.7% of GDP higher than this May 2018 estimate.

If the level of deficit is unremarkable, it is of course possible to be critical of the composition of the measures in terms of their expansionary potential – even though they reflect election commitments. There is little in the spending package for increased government investment, for example, despite its low level and the urgent need for infrastructure improvements.

But while the Commission could reasonably offer advice to governments on the content of their budgets, it is surely on dangerous ground to threaten penal sanctions because of disagreement over the policy mix.

Another recent criticism is that the putative stimulus package is actually not a stimulus. This comes from Olivier Blanchard, ex-IMF Chief Economist, and Jeromin Zettelmeyer, both now of the Peterson Institute for International Economics. Despite inclusion of a multiplier effect of 1.5%, they contend that the overall impact of the budget is likely to be contractionary, because the increase in interest rates it provokes will outweigh the (assumed) benefits.

But this raises a deeper issue. Is the increase in interest rates, if this occurs, a function of the package itself, or rather of a reaction to the expressed opposition of the European Commission and other institutions? In other words, would the interest rate rise reflect economic uncertainty in money markets, or political uncertainty caused by Commission opposition to the budget? It is hard to judge with certainty, but we feel it is likely that this public opposition to an objectively modest proposed expansion at a time of high unemployment has greatly exacerbated the market reaction.

We have elsewhere expressed concern over the EU’s lack of true democratic space in the economic sphere:

“Despite its commitment to democratic values, in one key area the European Union does not permit legitimate democratic choice, and that is the economic sphere. Because so much of the economic policy of the EU is embedded in its Treaties…there is a growing frustration that the democratic will of Europe’s people simply cannot be expressed if on any point it differs from that set out in the Treaties.”

These concerns are all the greater when, as we believe, a wrong-footed political response by the Commission is almost certain to strengthen a government of which the stronger component (la Lega) promotes reactionary policies that truly breach our shared democratic norms.

The European Union has a genuine interest in ensuring that no state undertakes economic policies that seriously damage its monetary union. But even if it is not perfect, the current Italian budget package comes nowhere near to doing so. It is a reaction to decades of decline and years of searing unemployment. To prevent a new wave of fascism or ultra-nationalism, the EU needs to respond by ditching its bias to austerity.

As a final comment, we note that the tension over the new Italian budget exposes the lack of political judgment by the centre-right parties throughout the European Union for at least two decades. The EU fiscal rules are dysfunctional. Long ago the progressive parties should have opposed them. They failed to do so. Now it is the right, the far-right in some cases, that may harvest the popular outrage against the budgets adhering to those rules.

This article first appeared on the Progressive Economy Forum website on 31st October 2018.