Economic View: Yes, Italians should speak up

As the eurozone's pain deepens in the months ahead, I suspect that Italian ideas for economic reform will gain more respect
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If Silvio Berlusconi has started a trend towards plain speaking in Europe, eurozone citizens may yet come to feel grateful for the vigour with which the Italian Prime Minister expressed himself, though not, of course, for the actual remarks he made.

The key problem in eurozone economics has been a lack of candour about the twin problems of monetary and fiscal management. Until you accept that both are in huge difficulty, you cannot hope to tackle the problem. Until you accept that the eurozone economy as a whole is heading towards a roadblock, you have no map to help you steer round it.

The plain fact is that, at the beginning of the year, the official position of the European Central Bank and the German, French and Italian authorities was that there would be growth in the eurozone of at least 1 per cent, maybe 2 per cent. Now, halfway through the year, the consensus is that growth will be around 0.5 per cent and that in Germany there may well be no growth.

Indeed, it may be worse. We know that in the first three months of this year, GDP in the eurozone failed to grow. I have just been looking at the new Deloitte & Touche Economic Review, which is written by Roger Bootle, the British economist who has had a very good track record in warning of the dangers of global deflation. This report suggests that the eurozone as a whole, not just Germany, may well go into recession this year. Almost worse, it believes that the pick-up in 2004 is likely to be very muted (see the first chart above). Eurozone citizens can put up with dreadful growth this year, but another year of economic failure would be really disturbing.

Certainly, both consumers and industry in the eurozone are profoundly gloomy, consumers even more so than they were in the mid-1990s dip (next graph). This is probably mainly the result of low growth in real incomes and rising unemployment, but it may also be associated with the surge in inflation that they perceived took place at the time of the introduction of the euro.

That ought now to settle down, particularly as the prospects for inflation have changed dramatically. As the next graph suggests, core inflation in the eurozone may fall close to zero next year. As that is the average for the zone as a whole, parts of it will experience deflation.

The Deloitte report suggests that deflation will arrive in Germany late this year and persist for much of 2004. Countries with economies closely connected to Germany, such as the Netherlands, Belgium and Austria, will probably experience deflation, too.

But this is still not accepted by the European Central Bank. Hardly anyone expects it to cut interest rates at its next meeting this week, which probably means the next reduction will not come until after the holidays, in September. Eventually, Deloitte thinks, the ECB will be forced to bring rates down to 1 per cent. But by then deflation will have taken hold.

With no growth to speak of, it seems inevitable that the budget deficits of France and Germany will remain above the 3 per cent Stability and Growth Pact both this year and next (see last graph). The German deficit may reach 4 per cent of GDP this year, making utter nonsense of claims even six months ago that Germany would stay below 3 per cent.

So the Italian presidency comes at a time when the credibility of two main elements of eurozone economic policy is shot to bits. What can it do?

There is a temptation to overstate the ability of any country to use its presidency to change things, but plain speaking instead of "euro correctness" would be a start. The portion of Italy's stated plans that relates to economic revival is its "action for growth" programme to increase investment on infrastructure. The idea is that money from the European Investment Bank will be released to fund it. There is nothing wrong with this in theory - counter-cyclical investment makes a lot of sense - but there are practical difficulties. One is the Japanese disease: using public funds to invest in fairly useless projects that happen to be in the constituencies of important politicians. The other is that the lead times on big infrastructure projects are so long that the investment does not come through when it is needed. By the time the big spending takes place, the economy has recovered anyway.

No, I think the bigger game is to do something about fiscal policy - not because it is more important than monetary policy but because the latter is a closed shop.

There are a number of interesting ideas around. These include redefining the 3 per cent limit to exclude some forms of public investment. Another would be to force adjustment during the up-phase of the cycle, rather than the down-phase. Governments should be forced to run surpluses in a boom and then be allowed to run deficits during a slump.

The formal objection to redefining the pact is that to do so would encourage fiscal ill-discipline. The practical objection is that greater public borrowing would push up long-term interest rates, of which it has to be admitted there is some evidence now. But Italy has given a fine example over the past five or six years by cutting its deficit from alarming levels. On fiscal policy, Europe should listen to Italy perhaps more than any other EU state for it has had the hardest task in cutting its deficit.

The trouble is that the eurozone is not in the mood to listen to Italy. But as the eurozone's pain deepens in the months ahead, I suspect that Italian ideas for economic reform will come to gain more respect, as they should. I'm not quite so sure about the EU's attitude to its new president, but that's a less important issue than getting growth going again.