We need to produce more, we must produce better: It is upon supply that we need to act. On supply! This is not contradictory with demand. Supply actually creates demand." -Former President of France, F. Hollande

By The Group of Fiscal Money (Biagio Bossone, Marco Cattaneo, Massimo Costa, Stefano Sylos Labini)

Charles Wyplosz’s commentaryon our Fiscal Money proposalreflects much of the famous endorsement of Say’s law that President Hollande made in 2014 as a guide for the future of the French economy (see epigraph).

Referring to our proposal, Wyplosz argues that “the economic analysis underpinning this proposition is exactly the opposite of what Italy needs,” and refuses to recognize “the lack of demand within [Italy’s] economic stagnation. He then goes on claiming that the remedy we propose aims at the wrong objectives and, by the way, it violates Maastricht…

Now, while it is realistic to consider that important supply-side impediments have long affected Italy’s competitiveness and economic attractiveness and should thus be removed, it is rather surreal to deny the devastating (economic, social and political) consequences that Italy suffered as a result of the demand depression following Europe’s sovereign debt crisis of 2011.

Let’s first briefly take on Wyplosz’s criticism of Fiscal Money and then discuss the supply-side issue he is so concerned about: Italy’s low productivity.

Fiscal Money

Wyplosz considers Fiscal Money as an “idea at the margin of rules” that allows the country to expand its public debt. Wrong on both counts.

Fiscal Money falls within precise rules and definitions established by the European System of Accounts. It is designed as a non-payable tax credit instrument according to Eurostat definition, and as such it is not debt and does not alter the fiscal budget at the time of issuance. A government that issues Fiscal Money doesn’t owe any money to its holders and cannot default on its underlying obligation. Based on existing rules, Fiscal Money has to be recorded in the budget only when redeemed by its holders and used for fiscal rebates; yet this can only happen two years after its issuance, when the output growth prompted by reinvigorated demand will have generated the resources needed to cover the rebates. Moreover, in the event that resources would not be enough, safeguard measures would be triggered that would automatically correct for the shortages, while new issuances would compensate those affected by the fiscal adjustment so as to make it less contractionary. To sum up: Fiscal Money is not at the margin of existing EU rules but squarely within them; also, by design, it cannot have negative budgetary effects.

Italy’s productivity: myths and truths

Prof. Wyplosz talks about Italy’s scant record of productivity over the last decades. Let’s take a deep look at the issue. Comparing Italy’s total factor productivity (TFP) and the country’s real effective exchange rate (REER),[1]Chart 1 shows that TFP has in fact continued to increase both when the REER strengthened (1976-1992) and when it weakened following the breakup of the European Monetary System (1992-1994).

Chart 1. Italy – Productivity and Real Effective Exchange Rate

Image placeholder title

Source:G. Iodice

[1]The REER is the weighted average of a country's currency in relation to an index or basket of other major currencies, adjusted for the effects of inflation. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index. This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index.

The apparent paradox is explained by what is known as Kaldor-VerdoornLaw, which Prof. Wyplosz totally neglects.[2]The law states that in the long run productivity grows proportionally to output. Its rationale is pretty much intuitive: when aggregate demand expands, and the economy grows, there follow more resources and stronger incentives to invest, such as larger scale and learning economies, greater specialization, incorporation of technological progress into capital formation, and cumulative growth processes.[3]

Up to the introduction of the euro, Italy’s real output and TFP both grew substantially and in tandem. Chart 2 shows the closeness of the country’s real per-capita GDP to the EU15 average until its dramatic reversal as Italy prepared to enter the euro. The strengthening of the REER during the period up to 1992 did not weaken economic growth but impacted the economy’s external trade balance. In the years between 1980-1992, the current account deficit in percent of GDP hovered around -1.5% and hit -3% in 1992 when Italy abandoned the EMS.

The subsequent exchange rate realignment was accompanied by a change in the sign of the trade balance, which in 1996 recorded a 2.5% surplus. With the anchorage of the lira’s exchange rate in preparation to the euro, the surplus progressively shrank until substantial external balance was achieved in 1998-2000.

Chart 2. Italy – Per-Capita GDP vis-à-vis Eurozone (12 countries)

Image placeholder title

Source:A. Bagnai

[2]In their recent NBER research paper, Mark Gertler and colleaguesnote that their results emphasize the importance of the effects that demand shocks have on the supply side over the medium term, and point to them as an important take away that can be used to explain productivity dynamics more generally.

[3]See Kaldor, N. (1966), Causes of the Slow Growth in the United Kingdom, Cambridge: Cambridge University Press.

The external balance, achieved in a situation of a normal demand growth, suggests that the exchange rate at which Italy entered the euro was not “wrong”, at least initially. Yet, from that point onward Italy’s output growth started to slow down. This was not due to the exchange rate over-valuation, but rather to the adoption of austerity policies aimed to bring Italy within the Maastricht parameters, in particular in relation to inflation and the deficit/GDP ratio.

The slowdown led to TFP stagnation, at the same time that Germany started to gain competitiveness not because of productivity improvements but as result of the internal devaluation policiesadopted to compress wages and salaries. The euro now in place avoided the exchange rate adjustments that in its absence would have caused the deutsche mark to revalue against the other currencies.

Italy entered a vicious circle: the combination of austerity policies, TFP stagnation and low competitiveness affected aggregate demand and output growth; the latter, in turn, further penalized TFP, and the crisis of 2008 precipitated the situation even further. As Table 1 summarily reports, Italy’s real GDP in 2017 was 5.5% lower than in 2007, while exports were up. Had GDP grown at the same rate than exports, 2017 GDP would have been € 241 billion higher (i.e., +14%).

Table 1. Italy since the 2008 crisis in a nutshell

Image placeholder title

Source: ISTAT – Preliminary 2017 data - € bln, constant 2017 prices

The nexus between the euro and TFP stagnation exists and the centrality of aggregate demand as an explanatory factor cannot be overlooked, as a large body of recent evidenceshows.

Italy’s “Made in Italy” problems

All this does not absolve Italy from past responsibilities and grave economic policy errors. And if this is what Prof. Wyplosz wants to hear from us, we don’t have any problem in saying it. Even under the impossibility of adjusting the exchange under the single currency, Italy should have adopted measures (not only in the realm of economics) to improve its business environment and competitiveness (and it still should do so). It didn’t, although it is fair to add that from 2011 onwards Italy did implement various fiscal adjustment measures, including to rein in pension spending and to make the labor market more flexible, as strongly recommended by the EU. The country’s primary surplus is among the highest in the world and has been the most stable among the EU member states for the past 23 years (Chart 3).

Chart 3. Primary Surplus of the Five Largest EU Countries: 1995-2016 (%GDP)

Image placeholder title

Source: European Commission

The problem is that these measures failed to deal with the huge demand slack created by the 2008 financial crisis first and the 2011euro crisis later. They were deflationary measures and predictably depressed output. In addition, they severely weakened the national banking sector.[4]

[4]From 2011, Italy’s non-performing loans (NPLs) as a percentage of GDP skyrocketed since 2011, while Italian banks had overcome the 2008 worldwide financial crisis better than most of their international competitors, due to low exposure to subprime lending and to derivative transactions.

There is no doubt that aggregate demand has a key role in explaining Italy’s productivity decline. Supply-side reforms may increase potential GDP, and structural interventions (such as on the judicial and governance systems and on infrastructures) could do a lot to improve TFP growth. But they would do little to close the huge output gap, while revamping demand is necessary for the country to extricate itself from the deadly trap into which it has fallen.

Italy’s productivity decline does not derive from technological discontinuities, geopolitical upheavals, or lack of entrepreneurial capacity. It is the result of a faulty institutional and economic policy architecture as well as of the erroneous and unsustainable policies that first accompanied its introduction and then ineptly tried to mend its manifest dysfunctionalities.

Fiscal Money starts from recognizing these shortcomings. It is not a panacea for all Italy’s problems. It only purports to kickstart a stagnant economy in a situation where public debt should not grow any further and where no resort is possible to other macroeconomic policy levers.

The Group of Fiscal Money

Biagio Bossone

Marco Cattaneo

Massimo Costa

Stefano Sylos Labini

Photo Courtest of Antonio Manfredonio