Sunday, November 13, 2011

How much Italian suffering is actually necessary?

Media outlets have almost universally described Berlusconi's resignation as the beginning of new, hard era for Italians, in which they might be subjected to harsh reforms designed to keep the nation's debt under control.
Both there and in Greece, jumbled parliaments came together with urgency to install more technocratic governments that are committed to delivering the difficult reforms and austerity measures demanded by the European Union, the European Central Bank and the International Monetary Fund.
That sounds pretty dire! Euro-centric technocrats swooping into government, carrying with them a new, tough agenda that promotes the welfare of international bodies and organizations.

How have the Italian people reacted to their plight? With, uh, raucous street celebrations.

Am I the only one who notices a mismatch here? Those celebrating Italians don't exactly have the look of people about to have their happiness crushed under the jackboot of internationalist technocrats.

On some level, this incongruity seems connected to something I don't understand terribly well about the eurozone crisis: why reform must be so difficult for Italy in the first place.

As far as I'm aware, Italy faces a very specific problem. While it is currently running budget surpluses, it has a massive amount of debt floating around. The key to keeping Italy afloat, then, is to ensure that it can continue to pay the interest on its debt, and, over time, pay down the principal as well. That in turn requires Italian GDP to grow -- either nominally, through inflation, or actually, through, well, economic growth.

The ECB seems presently unwilling to print money and assist Italy by inflating the euro. As a result, Italy has little choice but to seek a growth-oriented path out of the crisis. (This may not be feasible, of course, but bear with me.) That's ostensibly the agenda of the post-Berlusconi Italian national leadership.

But here's the thing: Italian economic growth is good for everyone, including Italians. Pro-growth reforms shouldn't be deeply unpopular -- they should be very popular! And yet, you'd be hard-pressed to find a prescription for saving the eurozone that doesn't yammer on about the need for Italy to impose "discipline" or "accept difficult reform." It's as if fixing the crisis entails whipping profligate Italians, and paying back bondholders with tears.

Look, no set of reforms is going to be all wine and roses for Italians. But, likewise, no plausible set of reforms should actually slow the Italian economy, either. Doing so would just make everybody worse off. So the idea that fixing the eurozone requires horrendous sacrifice from the Italian people just doesn't parse for me.

I don't get it. The interests of Italy and the interests of the rest of Europe seem at least somewhat aligned at the moment -- but nobody's seemed to notice, because they're too busy trying to instill some misguided moral order.


  1. I think your assessment of Italy’s problem is too simple. Yes, it needs to grow, but putting it in a position isn’t nearly as easy as passing “pro-growth reforms.” I agree that going through this adjustment is ultimately what’s best for Italy and the EU, but that’s only true over a five or ten year horizon. And even then, some Italians will probably lose out.

    (As an aside, I admit that I don’t know much about Italian politics. The reaction in the streets could be a knee-jerk response to the ousting of an unpopular and bigoted politician, or it could be a show of support for the new economic policies that Mario Monti is expected to pass. I suspect it’s the former, but I have no idea.)

    Italy is really facing three somewhat interrelated problems. First, it’s uncompetitive in the popular sense. That is, the economy isn’t flexible. Some professions are protected—it’s nearly impossible to fire people and very hard for new entrants to get jobs—while young people are often forced into low-paying temporary jobs that have little opportunity for advanced. Its tax code is burdensome. People work too little and retire too young. Second, it’s uncompetitive in the technical sense: it has become priced out of international markets. After the euro was created, euro appreciation and inflation pushed prices and wages too high, while wages in Germany and the rest of northern Europe were kept low (through political action and market forces). The result was a widening of the trade deficit in Italy (and other peripheral countries) and a widening of the surpluses in Germany. And third, it’s got the debt issue. It’s not quite running a surplus (excluding interest payments it’s expected to run a surplus this year or next) but its budget is in much better shape than the Greek or U.S. budget.

    Fixing these problems, particularly the second one, isn’t as simple as passing pro-growth reforms. For the first problem, the necessary reforms have clear winners and losers. Reforming the labor market is good for young people (which perhaps explains some of the celebrations) but bad for many professionals. Reforming the tax code almost by definition shifts the tax burden from one group to another. Raising the retirement age is unpopular, even among young people (look at France). So while these reforms may make the Italian economy more dynamic, they do so at the expense of the comfort that many Italians likely feel that they’ve earned.

    The second problem is even trickier. Having forfeited its ability to devalue, Italy has to restore its technical competitiveness through “internal devaluation.” (A depreciating euro will help, but the adjustments will be much smaller than they would be if the currency was backed by Italy alone. Moreover, a falling euro clearly does nothing to help Italy restore competitiveness vis-à-vis Germany.) Practically the only way to engineer an internal devaluation, however, is cutting wages. This is deflationary, distinctly anti-growth, obviously unpopular, and takes a long time to work. So for Italy to do this, it very much needs a technocratic government that is willing to administer painful medicine without worrying about popular opinion.

    Finally, the debt issue will require some degree of austerity. I wouldn’t have said this a year ago—had Italy done what was necessary to tackle the other problems then, I think it would have convinced markets that it was solvent and interest rates would have stayed around 4 percent. But now that interest rates are where they are (or where they were a few days ago), I think the damage is partially done and they won’t come back down to 4 percent for a long time, if ever. Unless they do, some budget cuts are probably necessary. And budget cuts are always unpopular.

  2. Of course, these solutions can compound the problems, making it even more necessary for governments to take a much longer view than is usual. Deflation makes debt harder to bear; budget cuts hurt growth and can be self-defeating. (Largely because of these problems, I’m not convinced that the current plan will work, but if it does, it will require endurance on the part of policy makers.) Only the first problem has solutions that are unambiguously good for Italy, but again, even these benefit some at the expense of others.

    There are probably other ways out, but they all require some sacrifice from Germany, which doesn’t seem forthcoming. The easiest option would likely be for the ECB to adopt more expansionary monetary policies and allow higher inflation in Germany. By increasing wages there, this would allow Italy to lower its relative wages (in the eurozone anyway) by holding wage growth to zero or something just above that, which is considerably less painful than actually cutting nominal wages. Some inflation would also ease the debt burden.

    So to the extent that a misguided moral order is imposed unnecessary pain on Italy, it’s coming from Mario Draghi, not Mario Monti. Without a change in EU politics, the policies of the Monti administration will likely be painful, unpopular, and necessary. While I’m certainly not convinced that a booming Italian economy will emerge from all of this, I don’t see any way for it to get there without going through a fair amount of pain first.

  3. I was sort of hoping you'd respond with something like that! Thanks!