Matteo Salvini has reignited Rome’s battle with Brussels over his public spending plans, and while financial markets ;are unimpressed, many international economists — who often dislike his politics — believe he might be right.
The European Commission wrote to Rome on Wednesday to warn Mr Salvini against his fresh bid to expand Italy’s budget, after the country’s deputy prime minister and leader of the anti-immigration League party called for a “fiscal shock” to boost growth.
But the commission’s concern is based on “nonsense” economics, according to Robin Brooks, chief economist of the orthodox Institute of International Finance, the organisation representing the world’s largest banks.
At the heart of the dispute is the concept of the output gap, a measure of how hot an economy is running. For any country, the output gap seeks to estimate how far the current level of economic output is above or below the level which would leave inflationary pressures stable. If actual output is significantly below potential, this implies the government has more leeway to increase spending to stimulate the economy until balance is restored.
The commission calculates that Italy’s output gap is almost zero — 0.3 per cent of national income this year, only a touch bigger than its estimate of 0.2 per cent for Germany. This implies that Italy’s economy has no more scope for additional growth than Germany’s does; therefore the commission opposes Mr Salvini’s spending plans.
Yet Italy has much higher unemployment than Germany, and Italian output per capita has fallen 2.6 per cent since 2000 while Germany’s has increased 25 per cent. Mr Brooks said these differences were “implausibly adverse” for Italy, adding that they “strain credulity when seen in a cross-country perspective”.
The commission’s technical reasoning fails properly to capture Italy’s potential for additional growth because it reflects the economy’s poor recent performance, not what would be possible with better policies, said Mr Brooks.
It is a fine judgment what is the right thing [for Italy] to do, but what isn’t a fine judgment is that the European Commission shouldn’t publish nonsense
The output gap is a theoretical construct because the potential level of output cannot be calculated with certainty; as a result, concerns are growing among leading economists that these technical estimates are becoming a curse.
One high-level official who is responsible for economic estimates at a leading international body told the FT that output gaps are “very sensitive” to data revisions and the current level of economic performance.
“As an economic variable used for policy, it’s very volatile,”said the official.
Olivier Blanchard, formerly IMF chief economist and now at the Peterson Institute, said: “We really do not know whether Italian unemployment can go down to, say, 6 per cent. I believe it can because when it did last time, there was no inflation pressure, and I see no reason why things should have changed very much.”
The danger, according to Adam Tooze of Columbia University, is that “politics [is being] pursued by the technical means of economics”, with the unintended effect of bolstering populist forces across Europe.
“It is a fine judgment what is the right thing [for Italy] to do, but what isn’t a fine judgment is that the European Commission shouldn’t publish nonsense,” said Mr Tooze.
The commission does not agree. Its officials recognise the uncertainties but insist their work is fair to all countries. A senior EU official said the methodology was developed over many years by member states themselves and “is never a mechanical extrapolation of one indicator”.
“The rules themselves foresee the need for an overall assessment and some discretion to allow for an economic judgment,” said the official. “The output gap is thus only one part of the overall framework to determine fiscal requirements and all relevant factors must be taken into account.”
But rarely has the commission come under such intense fire about a technical indicator. The stakes are high because the war over the output gap will determine how much room Italy’s populist government has for manoeuvre in the months ahead.
Some of the staunchest supporters of Brussels’ line come from inside Italy. Tommaso Monacelli of Bocconi University said there was nothing strange about estimates that suggest Italy’s potential output has not changed in the past 20 years.
“Italy’s economic problem is one of [low] long-run growth,” he said, adding that the weakness stems from years of low investment, R&D and technology adoption. “It is useless to think of expansionary fiscal policy as a way to jump-start the Italian economy,” he said.
Mr Salvini’s fiscal ambitions do receive support from some businesses. Angelica Donati, an executive in her family-owned construction company based in Rome, welcomed the government’s bid to relax public investment rules which “have effectively paralysed activity across Italy”.
However, that risks Italy being seen as willing to countenance corruption and poor procurement decisions, undermining markets’ confidence — a potentially substantial problem given Rome’s need to woo investors who hold Italy’s mountainous levels of public debt.
Mr Monacelli predicts the ruling coalition’s fiscal expansionism will lead to trouble ahead. “Italy is heading towards a possible financial crisis,” he said. “The key issue is really not about the decimal points of the Italian output gap, but much more fundamentally about the credibility of its government.”
On that, Mr Blanchard agrees. “They have to be smart about what and how they spend so as to avoid investors having a hissy fit. They are indeed between a rock and a hard place,” he said.
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