Is it possible to secure the Italian public debt? Clemens Fuest, director of the prestigious Ifo Institut in Munich, answers. On Focus he tries to analyze 6 possible solutions for the long-standing problem of Italian public debt. Clemens Fuest from Focus.de
The causes of Italy's high public debt are many, and all show a rather weak link with a frivolous budgetary policy.
There are several possible options to solve the problem of Italy's public debt, ranging from debt reduction, to asset tax, to exit from monetary union. But they all have disadvantages.
That is why it is likely that there will be strong tensions within the eurozone in the coming years.
The European debate on the economic situation, both in the crisis caused by the coronavirus and after the Eurocrisis, has always focused on the level reached by national public debts, public debt spreads and the consequences of a fall in government bond prices for Italian banks, which hold a significant share of these bonds.
Often in this debate, one gets the impression that Italy has found itself in financial difficulties only because of a rather frivolous debt policy. In reality, Italy's public debt is more a symptom of the country's economic difficulties than its cause. Where the real Italian problems lie becomes immediately clear if you take a look at the trend of Italian economic growth over the last four decades.
Italy is still suffering from the financial crisis.
The figure compares the trend of economic growth in France, Germany, Italy and the United Kingdom since 1980. Until the mid-1990s the economic development of these four countries was quite similar. After that, things changed radically.
In Germany, the pace of growth has slowed down in the meantime. The country had to bear the burden of reunification. Germany also entered the European Monetary Union with an overvalued currency. In Italy, however, growth continued to slow down in subsequent years. Until about 2005, Italian economic output followed roughly that of Germany. But then after the collapse due to the global financial crisis, Italy never recovered. While all the other countries considered here in the last ten years have returned to growth, the Italian economy has stagnated.
The reasons for this chronic weak growth have been discussed at length. The factors mentioned are manifold:
- The reforms of the education system in the 1970s and 1980s are often cited as a possible cause of low productivity.
- The emigration of talent has also weighed on growth.
- The judicial system works so slowly that contracts are often not applicable.
- China's entry into world markets since the 1990s has put Italian products under greater competitive pressure than those of other economies.
- The inefficient decision-making processes of family businesses are responsible for the fact that many of them have been unable to react to structural change. Moreover, the regulation of the labour market makes it difficult for companies to grow beyond a certain size.
- Some blame Italy's entry into the euro. It would have prevented Italy from devaluing its currency on a regular basis, as was previously the case.
- Still others point out the lack of reforms in economic policy during Silvio Berlusconi's governments.
- The fiscal policy implemented after the euro crisis, in particular the rapid return to a restrictive fiscal policy driven by financial market pressures and lack of public investment, would have hampered the economic recovery.
- Shortly before the crisis caused by the coronavirus, the conflict between the Five Star Coalition Government - Northern League and the European Commission about the budget deficit has put investors and consumers in crisis and weighed on economic development.
All these factors, presumably, have contributed to Italy's poor growth. It is a mixture of unfortunate circumstances and omissions on the part of political and economic decision-makers. Italy is entering the crisis caused by the coronavirus with a further growth in public debt compared to the level reached during the last economic crisis. The basic question is whether the country will be able to overcome the crisis by maintaining economic and financial stability in the coming months and years.
Six scenarios appear possible with regard to the development of Italian public finances:
1 - Stabilization of public debt at a high level with a slow reduction of the public debt/GDP ratio
It is theoretically possible that Italian fiscal policy could increase public spending during this crisis in order to stabilize the country's economy, while at the same time bearing the drop in tax revenue caused by the crisis. According to current forecasts, this would bring the public debt ratio to around 155 % of GDP. As long as interest rates on Italy's public debt remain low and creditors are willing to refinance the maturing public debt, the country will be able to live with high levels of public debt. In order to reduce this debt ratio significantly before the next crisis, economic growth in Italy will have to increase significantly. For the debt ratio to reach the level recorded before the coronavirus crisis by 2030, economic growth will have to be two percentage points higher than in recent years, with realistic primary surpluses. This would be a very optimistic scenario. This can only be achieved if the country implements far-reaching structural reforms and prioritises investment over consumer spending in its fiscal policy.
2 - Debt cut-off
It would be risky, but still conceivable, to reduce the Italian public debt by restructuring it. In order to assess the consequences of such a debt restructuring it would be important to understand who are the creditors of the Italian State. Italian households have a high level of savings. Italy is considered to be a country whose public debt is mainly held by its citizens. On closer inspection, however, this is only partly true. The structure of the Italian State's creditors in 2019 was analysed by Gros (2019).
In 2019 Italy's total public debt amounted to approximately €2,250 billion. Italian banks are by far the largest creditors. They have granted direct loans to the Italian government for EUR 290 billion and also hold Italian government bonds for a further EUR 400 billion. Italian households directly hold EUR 100 billion worth of government bonds. There are also investment funds and insurance companies with a predominantly Italian clientele. Foreign banks hold 450 billion euros in Italian government bonds. The Bank of Italy holds another 400 billion euro in securities, mainly as part of the ECB's securities purchase programmes. These bond holdings will continue to grow even during the post-Corona crisis. In principle, the Bank of Italy would be liable for defaults on these bonds. However, purchases of Italian government bonds by the Italian Central Bank generate liabilities to the rest of the Eurosystem within the so-called Target balances. It can therefore be assumed that the risks of this stock of bonds are ultimately borne by the foreign creditors. While a zero interest rate is currently applied to the Target liabilities, the proceeds from the assumption of this risk therefore remain in Italy.
In the event of a debt cut of, say, 50 %, most Italian commercial banks would have to be recapitalised, as losses of EUR 345 billion would occur. And this could only be done by drawing on a substantial part of Italian citizens' deposits and savings. It remains to be seen to what extent this could be compatible with European legislation on deposit insurance. Because of the losses on government bonds, investment fund shares and insurance directly held, there would be a further €350 billion of losses for Italian households. It is difficult to imagine that any Italian government would be willing to put savers in such a situation. Its re-election would undoubtedly be impossible.
It would also be difficult to persuade the European partners to cancel half of the Target loans to the Bank of Italy. It also seems difficult to expect foreign banks to incur losses of EUR 225 billion.
3 - A one-off wealth tax on Italians
Italy is often asked to reduce its public debt by applying a one-off tax on assets. In January 2014, the Bundesbank had already presented the concept of a one-off wealth tax as a means of avoiding the bankruptcy of the Italian state. The disadvantages and risks associated with wealth taxes, in particular the risk of capital flight, normally play against wealth taxes. However, situations are conceivable in which, in the absence of better alternatives, using this instrument might make sense: "In the exceptional situation of imminent State insolvency, however, a one-off levy on assets might have more favourable effects than the other options still possible".
However, such an asset tax would raise many problems. If it included movable assets, for example, it would lead to a capital flight. This would exacerbate the Italian economic crisis even further. Since large assets are often linked to companies, the tax would end up burdening companies that would have to invest and create jobs. To avoid capital flight, the tax could be limited to real estate. In that case, however, it would have to be proportionately higher. From the point of view of fair burden-sharing, however, it would be difficult to negotiate a cancellation of public debt exclusively at the expense of property owners.
4 - Shift the debt to other member states
It would theoretically be possible for the other member countries of the eurozone to relieve Italy of part of its public debt. The citizens of the other eurozone states, however, would never accept a direct redistribution of debt. It would therefore be conceivable for the other Member States to grant very long-term loans at interest rates close to zero, similar to those granted to Greece, for example, through the ESM. As long as these loans can be refinanced at an interest rate close to zero, there would be no problem. Creditor countries, however, may feel that there is no room for manoeuvre to borrow more, at the latest during the next economic crisis.
A generally used argument against shifting Italian public debt to other European countries is that Italian households often have relatively high levels of wealth. The graph shows that, although average net wealth is slightly lower than the eurozone average, it exceeds the wealth of Dutch and Finnish households, for example. It is difficult to imagine that in a country where households have lower average private wealth, they are then willing to ease the burden of the public debt of a country whose citizens are on average richer.
5 - Debt relief through the ECB
From time to time some people suggest that the problem of Italy's public debt should be solved by the central bank, which should buy most of the bonds and refinance the country. There are even calls for the central bank to waive interest payments and cancel the bonds. The proposal to eliminate public debt through the definitive transfer of government bonds to the central bank is as convincing as the famous lies of the Baron of MÃŒnchhausen. It is forgotten that the central bank's profits are still due to the state. If the Italian central bank, with the approval of the ECB, were to buy government bonds and issue them in exchange for money, this would create a central bank profit that would have to be transferred to the Italian government. If the central bank were to buy more government bonds, there would be less room, for example, to buy corporate bonds, given the total money supply. The interest income on these corporate bonds will consequently be lower. The plan to forget the public debt in the basements of central banks only works if you believe you can expand the money supply at will. But this is not possible. Anyone who tries to do so will cause monetary devaluation and inflation.
6 - The exit from the euro and the reintroduction of the national currency
The coalition government between the Five Stars and Lega Nord at the beginning of its mandate was openly discussing a possible exit of Italy from the Eurozone. This was accompanied by the idea that in this way Italy could get rid of much of its public debt by switching to a new national currency. The practical consequences of such a changeover - political and economic destabilization of the country and unpredictable legal disputes - however, make this option very unattractive. This is true for Italy and for the rest of Europe.
There is no simple solution
This brief discussion on possible scenarios for the future development of Italy and Italian public finance shows that there are no easy solutions to the problem of the country's high public debt. It is very likely that Italy will be financially supported by the Eurozone countries in order to guarantee the country access to capital markets at a low interest rate. The high level of public debt and the consequences of the post-Crown crisis for the private sector will put a strain on economic development, making it difficult for the country to emerge from a situation of excess debt. In the next economic crisis, over-indebtedness will be difficult to avoid.
The underlying political problem is that there will always be a strong temptation on the part of the governments in office to present over-indebtedness problems as merely temporary liquidity problems, postponing their solution by granting aid loans. The consequences will then be addressed by subsequent governments.
All this shows that considerable tensions will have to be expected in the euro area in the coming years. Italy is not the only country facing financial challenges. Much will also depend on whether Europe as a whole succeeds in relaunching its economic downturn as soon as possible. Whether this can be achieved depends primarily on developments in the pandemic and the government measures taken to contain it. The question also arises for European policy makers as to whether joint action at European level is possible to promote and relaunch economic recovery.e
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