Italy: A Glimmer of Hope

Something is happening in Italy. There is a faint glimpse of hope that one of Europe’s largest countries may be seeing the end of its tyrannical austerity policies. From the EU Observer:

Italy is set to move off the EU ‘crisis list’ this week, as the European Commission acknowledges its efforts to reduce its budget deficit. EU sources indicated on Monday (27 May) that Italy will be among several countries to be taken out of an Excessive Deficit Procedure (EDP) when the European Commission delivers its verdict on national reform programmes (NRPs) and budget plans on Wednesday (29 May).

The reason for this has to do in part with the latest austerity measures, in part with policies to end those. This sounds contradictory, but bear with me.

Austerity measures have a positive effect on the budget deficit in their first year. In other words, an initial upswing for government finances is to be expected under austerity. It takes a year for people to fully adjust their economic behavior to the new austerity measures. However, once the private sector has adjusted to government’s increased net taking of its resources, it produces fewer jobs and a smaller tax base than what government calculated with when it put its austerity package to work.

The net effect is a downward adjustment of economic activity, a loss in revenue for government and increased demand for poverty-related entitlements. The budget deficit bounces up again.

However, if you shift policies from austerity to a strategy that is more friendly toward the private sector, growth in employment, consumer spending and investments will grow the tax base and continue the improvement of the government budget.

This may actually be what is happening in Italy. But first, back tot he EU Observer:

Economic affairs commissioner Olli Rehn will deliver “country-specific recommendations” for each of the 17 members of the eurozone. Italy’s budget deficit is predicted to fall to 2.9 percent in 2013 before falling to 2.5 percent in 2014 and the country once regarded as too big to fail in the eurozone is no longer top of the commission’s at risk list. However, it is expected to remain in recession in 2013 before recording a modest 0.7 percent growth rate in 2014.

In order for the budget deficit to fall by 0.4 percent of GDP from 2013 to 2014 the government budget has to run a surplus of that amount. The tax base, GDP, is expected to grow by 0.7 percent which means that spending cannot grow faster than 0.3 percent of GDP.

While it is very unlikely that spending will grow at such a small rate, it is possible for the tax base to grow faster. Italy’s new prime minister,  Enrico Letta, wants to see a shift in policy from austerity, which increases the government’s net taking from the economy, to a more growth-friendly strategy:

The centrepiece of his tax pledge is the suspension of the hated property tax, known by its acronym IMU, that was imposed on primary residences by former leader Mario Monti and strenuously opposed by Mr. Berlusconi. He did not, however, vow to kill the tax. Some economists think it will ultimately be reduced or imposed only on residences above a certain value. He also said he hoped the planned hike in the value-added tax to 22 per cent from 21 per cent, another initiative of Mr. Monti, would not go ahead, and that taxes on employers – a “tax on jobs,” as he put it – would be cut. Mr. Letta is trying to gain European support for his anti-austerity, job-creation plans by visiting German Chancellor Angela Merkel and European Council President Herman Van Rompuy this week.

Not bad but not enough. Still, it is nice to see some European leaders ready to fight for common-sensical economic policies.

Then there is the mandatory short-sighted question:

How Italy will pay for these measures was left unsaid and Italy has virtually no flexibility, even though its sovereign funding costs are well below their crisis highs of 2011, when Mr. Berlusconi was effectively ousted and replaced by Mr. Monti. While Italy is not Greece, the country is in deep recession and is saddled with a ratio of debt to gross domestic product of 127 per cent, the second largest in Europe, after Greece.

It is precisely the wrong way forward to focus on how to pay for tax cuts. That notion presumes that the tax cuts will have no positive effects on the economy. If the pay-for-itself measure is about the government budget, there is little to fear. Tax cuts often pay for themselves, as was well proven in the U.S. economy during the ’80s.

If on the other hand the pay-for-itself question is related to jobs, GDP growth and a return to prosperity, there are reasons to not be as optimistic. The Italian recession is very deep and it will take a lot to put it back on a growth track again. Mr. Letta would have to pursue far bigger tax cuts than he is currently discussing.

That said, it is always better to cut taxes than to raise taxes. If the Italian government – and more importantly its buddies in the EU – can take their eyes off the government budget for a couple of years, then Italy might actually have a fighting chance to get back on track again. However, that chance would be much stronger if there was also a plan in place for structural spending-cut reforms. So far I don’t see any such plan on the horizon.

Bottom line: don’t count Italy out just yet, but don’t expect miracles from small spending cuts either.