The economic agenda of Italian populists is likely to exacerbate rather than alleviate Italy’s longstanding problems. But the piecemeal, small-step approach followed by European and national ruling elites, while perhaps tolerable for countries under normal economic conditions, is insufficient for an Italy stuck in a low-growth-high-debt equilibrium. If defenders of the European project want to regain popularity, they will need to present a clear functioning alternative to setting the house on fire.









Prompted by an unfolding political crisis and financial-market sell-offs, several international observers have only just tuned in to Italy’s current situation. Often, they have been shocked by the strength of support in an EU founder-country for parties embracing such inflammatory, populist and illiberal rhetoric.

In the best case, many have jumped to simplistic explanations, the most frequent of which argues that The League voters just seek lower taxes, while Five-Star Movement supporters – largely located in the poorer south – want easy money through a universal basic income. In the worst cases there have been arrogant explanations posited, along the lines of: “People don’t understand, they are irrational, or daft.”

Looking at the economics of Italian populism, most of the proposals appear to be superficial, unbacked by evidence or careful reasoning, and likely to augment rather than alleviate Italy’s longstanding problems – including poor competitiveness, shaky public finances, high spending on retirees and low spending on youth, and rising inequality. However, some of their premises are far from farfetched. In particular, they are rightfully calling out national and European ruling classes, who have prevaricated over long-known problems and inconsistencies, because they required hard choices.

In the Italian case, the orthodox toolkit does not hold bright hopes. The 1980s and 1990s were characterised by large-scale privatisations, which might have had a positive one-off impact but hardly set debt on a downward trajectory.

Though the list could be longer, two cases in point particularly apply to Italy. The first relates to public debt[1]. As is widely known, Italy has the fourth-highest debt-to-GDP ratio in the world, roughly 135%, and by now the government spends more annually on interest payments than on public investment[2]. Reinhart et al (2015) have shown how the debt levels we observe nowadays are unprecedented in advanced economies in non-war periods. They go on to show that the menu of solutions to reduce it can be divided between “orthodox” (fostering growth, privatisation, primary surpluses) and “unorthodox” (e.g. financial repression, inflation, restructuring, etc).

In the Italian case, the orthodox toolkit does not hold bright hopes. The 1980s and 1990s were characterised by large-scale privatisations, which might have had a positive one-off impact but hardly set debt on a downward trajectory. Running large primary surpluses is the official approach enshrined in the EU’s Fiscal Compact. However, Italy has run a primary surplus in nearly every year since the early 1990s. While some will claim that these should have been larger, Eichengreen and Panizza (2014) showed how the primary surpluses required to reduce debt significantly are rare birds in recent economic history and as such are unlikely to do the job for Italy[3].

The most favoured option is fostering growth, which usually comes as a recommendation to implement wide-reaching structural reforms. While this is a safe call[4], we know that reform waves have a heterogeneous impact and only occasionally yield the significant positive boost of the kind that Italy would need to break out of the current low-growth-high-debt equilibrium (Marrazzo and Terzi 2017; Peruzzi and Terzi 2018). In advanced economies, this has generally happened in post-military-conflict periods (Reinhart et al. 2015).

Unorthodox measures – though more frequently used in the past than we are often led to believe, even in advanced economies – are, however, generally against current EU treaties, or they cross red lines of other Member States.

Stuck between a rock and a hard place, the approach at national and European level has been to focus on the short term, employing a combination of the orthodox options, keeping fiscal accounts broadly under control, trying to reduce debt at the margin in good times, and hoping for a supportive external environment.

Unorthodox measures – though more frequently used in the past than we are often led to believe, even in advanced economies – are, however, generally against current EU treaties, or they cross red lines of other Member States.

The second case in point relates to the euro-zone architecture more broadly. By now, it is widely accepted that economic and monetary union (EMU) as it stands is incomplete and dysfunctional, leading for example to harsher drops in GDP during bust cycles (Martin and Philippon 2017). While individual solutions to this problem differ, most economists agree that without a political union the whole euro construct cannot hold together long-term[5]. Having concluded that this is politically unfeasible, the approach has been to focus on short-term patches and hope that a crisis as large as 2008 will not hit any time soon.

This piecemeal, small-step approach might be tolerable for euro-area member states under normal economic conditions. However, in a country that underwent 20 years of real GDP stagnation, and with no clear path to exiting this negative equilibrium in the near term, radical changes are more likely to be sought rather than small tweaks around the status quo.

As Harvard economist Dani Rodrik recently remarked, at least Italian populists are clear about how to solve his famous trilemma[6], which in a euro setting states that it is impossible to simultaneously have a functioning EMU, national sovereignty, and democratic politics. National and European ruling classes are yet to provide a clear answer. If defenders of the European project want to regain popularity, they can no longer hope to brush problems under the carpet and will need to present a clear functioning alternative to setting the house on fire. The current populist agenda might well lead to a poorer Italy; however, simply highlighting the sharp costs of dismantling the status quo will soon no longer suffice.

[1] A useful reference for this is “A New Start for the Eurozone: Dealing with Debt” by Corsetti et al (2015)

[2] See “Clouds are forming over Italy’s elections” by Terzi (2018)

[3] In their words, “The point estimates do not provide much encouragement for the view that a country like Italy will be able to run a primary budget surplus as large and persistent as officially projected”.

[4] On this point, it is worth remembering a quote of the World Bank chief economist: “Structural reform is safe advice. No one knows what it means. If economy grows: I told you. If it stalls: You didn’t do structural reform.”

[5] See “Does Europe Really Need Fiscal and Political Union?” by Rodrik (2017)

[6] https://twitter.com/rodrikdani/status/1000849241160540161

Bibliography

Eichengreen, B., & Panizza, U. (2014). A surplus of ambition: can Europe rely on large primary surpluses to solve its debt problem? NBER Working Paper, 20316.

Marrazzo, P. M., & Terzi, A. (2017). Structural reform waves and economic growth. ECB Working Paper Series, (2111).

Martin, P., & Philippon, T. (2017). Inspecting the mechanism: Leverage and the great recession in the eurozone. American Economic Review, 107(7), 1904–1937. doi:10.1257/aer.20150630

Peruzzi, M., & Terzi, A. (2018). Growth acceleration strategies. Harvard CID Working Paper SeriesCID Working Paper, (91).

Reinhart, C. M., Reinhart, V., & Rogoff, K. (2015). Dealing with debt. Journal of International Economics, 96(S1), S43–S55. doi:10.1016/j.jinteco.2014.11.001