Global markets, policymakers, and risk managers are watching the budget skirmish between Italy’s government and the European Commission closely. The episode highlights a growing tendency among governments in both advanced and emerging economies to question economic policy orthodoxy. As this trend intensifies, economists and market participants need to think harder about, and communicate much better, the implicit tradeoffs of conventional economic and financial policymaking under challenging circumstances.
Having been elected with a mandate to promote faster, more inclusive growth, the Italian authorities are pursuing a more expansionary fiscal stance. Their budget, however, has been “rejected” by the European Commission for its “non-compliance” with EU deficit rules. As a result, Moody’s has since downgraded Italy’s sovereign credit rating to just one notch above junk level, citing worries about the country’s debt stock and the government’s overoptimistic growth projections.
With Italy’s leaders insisting that they have “no Plan B,” spreads on Italian government debt have risen back to levels not seen since the dark days of euro crisis. And as both public- and private-sector borrowing costs increase, some observers are starting to worry about the implications for the Italian financial system. In fact, some have even gone as far as to argue that Italy poses an existential threat to the eurozone. Others, however, dismiss this as dangerous hype, given that Italy still has a manageable short-term debt-servicing profile, a primary budget surplus and a current-account surplus, as well as considerable economic potential.
Italy’s longstanding growth challenge is being amplified by Europe’s recent loss of economic momentum, regional fragmentation pressures, and the gradual reduction in liquidity injections by the European Central Bank. To counter these factors, Italy is resorting to fiscal policy to try to stimulate growth through both demand and supply channels. In other words, the government wants to run a larger budget deficit now in order to generate higher actual growth and higher potential growth.
Shift in global markets
Meanwhile, the pressure on Italian risk spreads has been accentuated by a shift in global markets. The past several years have been characterized by unusually low market volatility and an appetite for higher risk, owing to ample, repeated, and predictable liquidity injections from central banks. But markets are now moving toward greater risk aversion and higher volatility as monetary policies tighten and as growth – particularly in advanced economies outside the US – slows and becomes more divergent.
Looking ahead, much will depend on whether Italy’s big policy bet can be reconciled with the rules and guidance of the European Commission. But make no mistake: global factors will also play a role, not least by determining how much time Italy and the Commission will have to sort out their differences.
Precisely how regional and international factors evolve will have important implications for Italian sovereign spreads. An orderly policy transition would provide breathing space for the government’s economic strategy to evolve, whereas an abrupt shift would create significant headwinds in the form of tightening financing conditions for the Italian government and private sector.
This is not the first time that a newly elected government has challenged economic orthodoxy in the advanced world (the phenomenon is usually associated more with emerging economies). Upon taking office in January 2015, Greece’s Syriza government signaled its departure from the conventional approach adopted by its predecessors, even going back to the electorate for re-affirmation in a nationwide referendum. In the end, though, the threat of losing eurozone membership forced it back to policy orthodoxy.
In the United States, the Trump administration and congressional Republicans pushed through a late-cycle fiscal stimulus, cutting taxes and raising government spending at a time when the US economy is already growing rapidly due to higher consumption and business investment. Normally in an aging expansion, the government looks for ways to increase its policy flexibility as preparation for a possible future downturn. But, here, pro-cyclical policies were accompanied by a more confrontational approach to trade. Needless to say, this, too, runs counter to economic orthodoxy which regards trade as mutually beneficial, and protectionism as unnecessarily costly.
Rewriting the rules
Likewise, Turkey has been busy rewriting the rules of crisis management. So far, at least, President Recep Tayyip Erdoğan’s government has managed to overcome a currency crisis without aggressively raising interest rates or seeking financial support from the International Monetary Fund.
These unorthodox policy approaches are fundamentally challenging the conventional wisdom on how economic policies should be sequenced. For example, both Italy and Turkey have dispensed with the dictum that macroeconomic stability must come before growth-promoting fiscal and monetary stimulus. Or, as the old saying goes: Macroeconomic stability isn’t everything; but without it, there is nothing.
The increasing appeal of unorthodox policy approaches is the direct result of years of slow and insufficiently inclusive growth, coupled with mounting concerns about the inequality trifecta (income, wealth, and opportunities). These factors have undercut advanced economies’ actual and future potential, alienated significant segments of the population, eroded the credibility of the establishment and expert opinion, and fueled the politics of anger.
Rather than dismiss the reaction out of hand, experts should be more open-minded when grappling with the factors behind the new unorthodoxy. Specifically, the tradeoffs that are implicit in conventional approaches need to be carefully quantified and clearly communicated. And those approaches should be updated for a world in which anemic growth seems to have become a structural feature of a growing segment of economies.
In a world of self-reinforcing expectations and multiple equilibria, careful efforts to jump-start economies might facilitate the success of more durable structural reforms. In the case of Italy, then, the EU should remain flexible. But the Italian government must also demonstrate that it is a lot more serious about implementing the supply-side changes needed to sustain faster growth in the long term.
Mohamed A. El-Erian, Chief Economic Adviser at Allianz, was Chairman of US President Barack Obama’s Global Development Council and is the author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.
Copyright: Project Syndicate, 2018.