Euro

“Italy, center of the Euro Tragedy”

We have interviewed Ashoka Mody, visiting Professor of International Economic Policy at Princeton University, former deputy director of the International Monetary Fund’s European Department, and chief representative to Ireland during the Troika bailout. Author of the Eurotragedy, a Drama in Nine Acts. Mody is critical of how the Eurozone is being currently managed and sympathizes with Italy’s new spending proposal.

 Dear Mr. Mody, you said in a recent piece on Bloomberg that Italy needed a fiscal stimulus, and so increased spending to avoid an “unmanageable crisis”. What would this crisis look like?

Italy’s latest economic slowdown started around January, hence well before this current government came in. The pace of world trade had begun to slow down. The Italian economy moves in close tandem with world trade – when global trade growth increases, the Italian economy does well and when trade slows, so does the Italian economy. With world trade growth below 4 percent, as is currently the case, Italy has historically tipped into a recession. A recession will push up the government’s debt to GDP ratio. The interest rate paid by the government will rise, triggering the sovereign bank “doom loop” – a term used to describe how a rise in government’s interest rate creates losses on banks’ holdings of government debt, which pushes prices of bank stocks down – a weak government and weak banks make each other even weaker. The Italian economy is on the edge of such a loop. To be clear, a recession is likely regardless of what happens in Brussels and Rome, simply because world trade is slowing down. It would, therefore, be a mistake to follow the original agreement between the European Commission and the previous government because that requires austerity. Today, austerity makes no economic sense because, if enforced, it would make the impending recession even worse. Italy needs a modest stimulus.

Speaking of recession, how effective do you think Mario Draghi’s leadership of the European Central Bank was in resolving the Eurozone crisis with quantitative easing?

This is a very difficult question to answer. As everyone agrees, quantitative easing came too late. The delay allowed low inflation tendencies to set in. The ECB seems a bit helpless. It has been predicting since 2014 that inflation would rise back to 2%, but there is no sign of such a rise. The ECB has also been unable to use quantitative easing, as other central banks have done, to make the euro depreciate – which would help raise inflation and economic growth. The ECB never seemed committed to quantitative easing – and started talking of tapering in early 2017. Hence, the euro remains strong for the weaker countries and relatively easy for the stronger countries, which is the original flaw of the Eurozone. In other words, different economies have different necessities, and in this case the weaker countries have to deal with this monetary policy that is suited for the strongest members. I also don’t see any evidence that the ECB’s QE raised growth. In 2015 and 2016, the first two years after QE’s introduction, Eurozone growth remained low because world trade growth was low. In 2017, when world trade picked up, eurozone growth increased. The ECB took credit for the rise – but really, no credit is due to the ECB. The whole world grew in 2017. Now that growth has slowed, the ECB says it is temporary – that follows a typical ECB pattern of denying the problems it confronts. The reality is that the slowdown is not due to temporary factors, it is set to continue, and in the next few months it will become more evident. So why won’t the ECB do more? Because it has a fundamental problem – political interests within the governing council are limiting its actions.

And what are the political interests limiting the ECB from acting on this problem, which harms the weakest countries in the Eurozone?

The members of the governing council represent different countries with different national interests. Resolving those differences and achieving a compromise slows down the decision-making process. At times, German and northern interests have clearly dominated, for example between 2013 and 2015. Germans took the lead in delaying QE.

Do you think Italy should lower its deficit to GDP ratio of 2,4%, even o a marginal 2% to appease the Commission, or should it demand that the European Union accept its spending program even if this means the risk of sanctions?

First, there will never be sanctions. Chancellor Angela Merkel once called them “idiotic.” Even European leaders will not add financial sanctions to make a bad problem worse. On substance, the difference between 2.4% and 2.2% is meaningless. We are not in a chemistry lab, making fine measurements of sub-atomic particles. In economics, such precision is silly. The focus of the Italian government should most importantly be on the projected growth numbers, which are far too optimistic. Because economic growth will be slower, the revenue shortfall – and, hence, the deficit – will be greater than 2.4%. The current government should scale back some of their spending ambitions, not because the Commission requires it but because the lower-than-projected growth could push the deficit too high. That said, some stimulus is necessary. I am, in principle, sympathetic to the government’s proposal, because I believe that more austerity would be a disaster. The stimulus is needed to compensate for slowing world trade, but the size of the stimulus needs to be set with a realistic growth forecast.

In light of these circumstances, how realistic do you see the possibility of Italy leaving the euro? What are the risks and benefits involved in such a decision?

In my book, I make it very clear that an Italian departure from the Eurozone would be a huge mistake both for Italy and for the rest of Europe. Everyone would suffer, because if the Italian economy moves back to the lira, repaying the debts that are due in euros will become virtually impossible. I know many believe there are clever tricks to try to avoid defaults. I don’t believe those tricks will work. There will be large-scale defaults, and because the Italian economy is so large, cascading effects from Italy – as Italy’s creditors default on their creditors – will cause enormous damage to the Italian, European and world economy.

What do you say to people who are nostalgic to the lira, when things were better?

Nostalgia is not very useful to making economic policy. Leaving the euro is too costly. The parallel currency is also a ridiculous idea – it has never worked in practice. With a parallel currency, the fundamental problem of repaying debts due in euros will remain.

Do you think Italy risks a potential economic scenario like Greece?

If there is an enforcement of austerity at this point, given the recessionary conditions that Italy is already in, there is no question that the Greek story will be grimly repeated. Austerity will make the recession worse, the debt to GDP ratio will go up, so the Commission will demand more austerity. That is the cycle Greeks went through, and repeating it would be a catastrophic mistake.

What do you think of the new proposal made by German Chancellor Angela Merkel and French President Emmanuel Macron on a new Eurozone budget to unify the Union even more, where only members who “respect the rules” could access it?

I don’t understand how serious people take the French and German proposal seriously. This is an example of what I call this “involution” – when it becomes impossible to make genuine progress, people create work to give themselves the sense that they are doing something useful. First, the size of the proposed fiscal transfers is trivially small. In addition, the idea that rules would need to be respected to receive those transfers is utterly mindless. For example, if the Italian government could receive a transfer only if it “follows the rules”, then (as today) there would be a debate for six months on whether the rules were being followed or not. By then, it would be too late for the transfer to be useful. To be useful, the transfer needs to be automatic, with no questions asked. Otherwise it’s not a transfer. The whole thing is a bit of a joke, and I doubt if the idea will survive.

How strong is Italy’s economy, in reality compared to other European powers like Germany and France?

 The Italian economy is plagued by many problems—low productivity growth, fragile banks, and a highly indebted government. The central problem, however, is the dismal productivity growth, which over the past two decades has been negative – productivity has actually fallen by over 10 percent. Italy does worse on this score than any other eurozone economy. The problem lies in weak schools and universities, which results in extraordinarily low research, development, and innovation. Italian governments have only themselves to blame for this outcome. The result, however, is that whenever the Italian economy approaches a recession, as is now the case, it has little internal strength to pull out of the recession. The economy needs the help of easier monetary policy and a weaker exchange rate. However, this not possible in a monetary union. That is why I call Italy the theater of EuroTragedy.