Italy's `olive tree' coalition may yet surprise Europe
Tuesday 23 April 1996
Part of the reason for this positive reaction to the "olive tree" coalition victory is fear of what might have been: yet another hung parliament, leading to continued policy paralysis. Part is a celebration of the progress of the real economy now that politics, for the moment, are out of the way. Part is a delayed market local reaction to financial changes taking place in other European markets. But (and this is the most interesting bit) part may be a judgement that Italy can and will continue on its slow return to fiscal virtue under a left-of-centre government.
The first point - that the real economy will move ahead if Italy is a success story - is widely appreciated. The depreciation of the lira has helped. Anyone who has visited the northern half of Italy recently will be aware that it is achieving a recovery comparable with that of the UK, and far more vigorous than that of France and Germany. Its export success has even led to attacks that it has deliberately sought to gain competitive advantage by devaluing the currency.
That is surely not just unfair but impossible: the exchange rate of floating currencies is set by the market and the market has taken a dim view of Italy's financial management. In any case in the last couple of months the lira has risen sharply. But at the cost of some inflation (retail prices rose more than 5 per cent last year) and double-digit interest rates, a reasonably solid economic recovery has been established.
Italy managed 3.2 per cent growth last year and even if it achieves only 2 per cent growth this, that would be better than that of France or Germany.
The delayed reaction is also fairly easily explained. Alone among the western European countries, Italy has not had a reduction in its official interest rates for more than a year, so it has some catching up to do. A cut in short-term rates following last week's cut by the Bundesbank is an obvious early possibility. As for expectations of a rise in the lira against the mark, the exchanges are in any case expecting some generalised further mark weakness, so it would be wholly natural for weakness against the lira to be part of this.
In addition, there is the possibility, even the probability, of the lira rejoining the European exchange rate mechanism later this year to give a little spice to potential investors both in lira paper and in the lira itself.
But it is the third element of the group which has the widest resonance for other European countries.
If there is a real possibility that a left-of-centre government is at least as able as a right-of-centre one to run a tight fiscal policy, cut inflation, and hence cut interest rates, then the experience of Italy carries implications for the rest of Europe.
The Italian debt story can be swiftly told. In 1980 Britain and Italy had roughly the same sized national debt as a proportion of GDP: it was slightly larger but not much. Now ours is about 55 per cent of GDP, while Italy's is 125 per cent (see right-hand graph). As a result (see left- hand graph) simply paying interest on the national debt is taking up 20 per cent of tax revenues, and is equivalent to 11 per cent of GDP.
That is an absolute killer. If one-fifth of one's revenues go straight out in interest payments just getting back to a situation where the debt does not keep growing explosively is tough. For reaching what is called a "primary balance", having tax revenues cover actual current spending is not nearly enough; you have in addition to run a large enough primary surplus to stop the debt growing even more.
Now look at the centre graph. Italy has been running a primary surplus since 1992, but an insufficiently large one to stop the deficit growing even larger.
Last year, finally, the primary surplus was large enough to stabilise the debt, not in absolute terms, but as a percentage of GDP. Estimates for this year suggest that again the debt ratio should be stabilised.
On the face of it, Italy has a long, long slog ahead simply to stop the deficit rising further. Unlike the UK after the last war (when our debt- to-GDP ratio rose to more than 200 per cent of GDP) Italy cannot expect a period of negative real interest rates or of high world inflation which would reduce the debt-service burden.
The key to making the burden acceptable, though, must be to reduce real interest rates as far as possible. As NatWest Markets (from whom those charts are taken) points out, real long-term interest rates in Italy are now 6.2 per cent, compared with 4.5-5 per cent in core European countries like German and France. Even that is historically high.
During the last century real long-term interest rates for good-quality government paper were 3-4 per cent, so there should be scope for cutting the debt service burden by up to half. If Italy could do that, then a dreadful budgetary situation would become a manageable one.
But to do that needs two things. They are obvious enough. The first is to continue running a sufficiently large primary surplus to stop the debt to GDP ratio rising any further and ideally to start pulling it back.
The other is to offer a sufficiently good macro-economic climate that rising investor confidence will start to cut the real cost of borrowing. The second depends on the first.
This is unpleasant for the obvious reason that it means less money for public services, but there is no other way. While the debt to GDP ratio has continued to rise through the early 1990s, some progress has been made. At least Italy is running a primary surplus, which it was not doing as recently as 1990. So the question now is whether a centre-left government has more legitimacy than its predecessors in carrying on more of the same sort of policies. It does not have to change direction, for that change has already occurred.
Now these are early days. The government is not yet formed so it is a bit ridiculous to start trying to call its economic policies, certainly from this distance. But that is why the market reaction is so encouraging. The professionals, who have no necessary love of the left, are implicitly saying that they believe that the balance of probability is that the process of fiscal reform will continue. That is the only rational justification for the surge in the markets yesterday.
There are precedents here. One is in Sweden at the moment, where the Social Democrats are gradually (maybe too gradually) pushing through a budget stabilisation programme.
Another, which might spark distant memories, was the UK fiscal programme instituted at the behest of the IMF by the last Labour Chancellor, Denis Healey, in 1976.
It would be silly to try and draw too close a parallel there, but it is worth noting that sometimes governments of the left follow tighter fiscal polices than those of the centre or the right - sometimes.
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