The election of Emmanuel Macron as president of the French Republic and the acquisition of the parliamentary majority by his En marche movement have relaunched the prospects for Franco-German collaboration and have given new impetus to the process of institutional and political advancement of the European Union and, in particular, of the Euro-area. If Chancellor Merkel's expected electoral victory takes place in September of this year, for the first time in about fifteen years there will be the opening of a coordinated political cycle in the government of the two major economies of the Euro-area. Indeed, the expectation of the event is already strengthening the dialogue between Paris and Berlin. The result could translate into the implementation of the path, outlined by the European Commission at the end of last March (see Reflection paper on the deepening of the economic and monetary union) and based on the recovery and deepening of many of the themes evoked by the Report of the Five presidents (Completing Europe's economic and monetary union, June 2015)
It is important that Italy offers its active contribution to this path in order to guide it towards satisfying both the general interests of the entire European Economic and Monetary Union (EMU), and the protection of its most fragile member states. President Macron has repeatedly reiterated the importance of Italy's role, perhaps also to reduce the risk that Germany's preponderant weight erodes France's bargaining spaces. Chancellor Merkel herself seems willing to involve Italy and Spain in the new European construction site, giving a sign of confidence in the process of integration of the euro area. However, the strong political and financial uncertainty that has characterized Italy since autumn 2016 has been a brake on any initiative aimed at strengthening shared responsibility within the EMU.
In this Policy Brief, the Luiss School of European Political Economy presents a hypothesis for the completion of the institutional set-up of the euro area which satisfies two conditions: it is acceptable to Italy's main partners because it is able to safeguard the accountability requirements and stability of each member state; ensure support for growth, which is essential for Italy, through the advancement of European economic cooperation. In fact, it is a question of achieving that balance in the trade-off between stability and growth, which can reconcile the distinct visions of Germany and France but above all the fundamental differences between Germany and Italy.
Over the past decade, the governance of the euro area has been changed in response to the challenges posed by the crisis. The European institutions have decided to strengthen the surveillance of the budgetary policy of the member countries, above all through the Six Pack and the Two Pack. In parallel, they have created the European Stability Mechanism (ESM) with the aim of providing financial assistance to those member states that had temporarily lost access to the market for financing their public debt. As highlighted by the European aid plans for Ireland, Portugal, Greece and Cyprus, financial assistance is conditional on a macroeconomic adjustment program subject to conditionality. Subsequently (2012), the ESM had the task of implementing three "facilities". The first took the form of the possibility of providing direct or indirect loans for the recapitalization of European banks (the Spanish case). The second facility concerned precautionary financial assistance, through the opening of credit lines, in favor of countries able to satisfy the main European rules ex ante but unable to finance themselves on the market at non-penalistic conditions. The third facility linked this precautionary financial assistance to the "Outright Monetary Transactions" programme, which allows the European Central Bank (ECB) to purchase an unlimited amount of sovereign bonds of a member state in temporary difficulty on the secondary markets.
The first facility, implemented by the ESM, has been modified by the establishment of the Banking Union, whose architecture is currently composed of the Single Supervisory Mechanism and the Single Resolution Mechanism and will have to be completed by a European Deposit Insurance (EDIS) scheme. Note that the EDIS has not yet seen the light due to the fiscal implications of a possible resolution of banks, which have large amounts of government bonds of their country on their balance sheets. However, if it is recognized that the Banking Union is now operational, the original rule provides that the ESM loans for the recapitalization of European banks can be disbursed directly, i.e. without weighing on the balance sheets of the countries to which the banks involved belong. The problem is that the methods of this direct disbursement need to be redesigned since, in their current form, they pose such complex conditions as to be difficult to implement. Furthermore, as part of the resolution processes, the ESM may be called upon to carry out a "last resort" intervention (public backstop) if recourse to the bail-in (for at least 8% of the assets of the bank involved) and the Single resolution fund (up to 5% of the assets of the bank involved) proves to be insufficient to cover liquidity and restructuring needs. As was recently demonstrated by the resolution process of Banco Popular in Spain and the problematic liquidation of the two main Veneto banks in Italy, this backstop function could prove crucial and should therefore be strengthened.
These considerations show that the governance system of the EMU, as it emerged after years of profound difficulty, has a more stringent surveillance mechanism and is equipped to deal with liquidity crises by a member state or some banks. However, it is not adequate to prevent or regulate a structural crisis of insolvency of a country or a national banking sector. With regard to the traditional European aid plans for the member states, the ESM funding is subject to too severe adjustment conditions so that, to counter the public debt crisis, there is a tendency to trigger a recession in the country involved and in those it more related. Concerning bank insolvencies, the implementation of the bail-in is facing strong resistance and the single resolution fund is still under construction. Furthermore, it has already been said that an agreement has not been found to create a European deposit insurance system capable of avoiding, due to its common nature, a vicious circle between banking crises and the sovereign debt crisis of a member state. In addition, the functioning of the ESM is hampered by internal governance problems, as many of its decisions must be taken unanimously and - in some cases - are subject to the approval of national parliaments.
Such deficiencies have spurred new proposals. In particular, Germany and France have suggested the creation of a new institution which, starting from the current functions of the ESM, can overcome the open problems in terms of fiscal policies. However, the positions of France and Germany show significant differences regarding the definition of the nature and tasks of the new institution and, consequently, regarding the priorities to be implemented.
Germany proposes that the ESM remove the responsibility for overseeing the budgetary policies of individual member countries from the European Commission, considered too politically susceptible. The ESM would thus be transformed into a European Monetary Fund (EMF), possibly headed by a European Minister of Finance, with the aim of protecting the fiscal stability of governments and the structural stability of banks. France does not oppose the transformation of the ESM into the EMF. In line with the position of the European Commission, however, it conceives the EMF as the instrument of a forthcoming European Ministry of Finance (MEF). The EMF should, first of all, create the conditions for that delegation of sovereignty on the part of the member states in matters of fiscal policies which is necessary for the progressive creation of the MEF. When fully operational, the latter would assume a more defined responsibility in defining the European fiscal stance and in the coordinated management of the budgetary policies of the various countries. It could thus achieve a harmonious division of labor with the European Commission, possibly strengthened by the expectation that the new European Finance Minister would also become President of the Eurogroup and Vice-President of the Commission (with responsibility for economic affairs). In addition to ensuring the financing of the traditional European aid plans of member states in serious difficulty and carrying out the three facilities mentioned above (see point 2), the ESM-FME would also have the task of fiscal facility for the MEF.
The German and French proposals are not immediately reconcilable because they have two different objectives: the first aims at centralizing the fiscal stability functions of the EMU, the second aims at centralizing budgetary policies and making them compatible with the cyclical trends of the Euro-area. Regardless of the fact that the EMF itself could be subject to excessive politicization or turn into an undemocratic authority, Germany aims at a preventive reduction of fiscal risks in the euro area. In fact, the establishment of the German model of EMF would impose a centrally controlled path of fiscal consolidation on France and – even more – on the most economically fragile countries (such as Italy). On the other hand, the creation of the French MEF model would require Germany and other 'core' member states (primarily the Netherlands) to increase domestic nominal wages and/or to relaunch public investment, in order to reduce imbalances positives of its current accounts. Perhaps overestimating the spillover effects on other member states deriving from an expansion of the German and Dutch public budgets, France thus aims to trigger more solid growth in the euro area through gradual adjustments of national public budgets and weak forms of sharing tax risks.
Beyond their diversity, both the German proposal and the French proposal capture a crucial point for the economic and institutional evolution of the Euro-area: the growing importance of European budgetary policies. European monetary policy is running out of room to support expansion of the euro-area economic cycle. Many signs indicate that the ECB will start, in the short term, a process of normalizing policy interest rates and reducing its government bond purchase programme. Accompanied by the increasingly moderate tone of US monetary policy, these initiatives will cause a rise in the structure of market interest rates which will hit, above all, the European countries with the most serious public budget imbalances. Therefore, it is easy to foresee that the attention of the financial markets towards the financing of public debts will sharpen starting from the autumn of this year. This does not mean that the EMF or the MEF are called upon to replace the ECB's quantitative easing (QE) programmes. It means, more simply, that monetary policy is ceasing to be the “only game in town” and is set to give greater scope to fiscal policies aimed at preventing and, where appropriate, bringing under control the most severe shocks.
The foregoing considerations imply that, in order to make the process of strengthening the euro area effective, the different positions of Germany and France on governance and fiscal policy must not turn into an irreconcilable opposition. In this regard, it is necessary for these two positions to escape the old controversy between 'risk reduction' and 'risk sharing'. It is a question of identifying a compromise that safeguards the objectives of both countries. Sapir and Schoenmaker (see We need a European Monetary Fund, but how should it work, Bruegel, May 2017) take a first step in this direction, drawing inspiration from the current division of labor between the single supervisory mechanism and the resolution mechanism in the framework of the Banking Union. In fact, the two authors propose that the European Commission continue to monitor the fiscal policies of the member states in normal economic phases and that the ESM-EMF assume this same task in phases of crisis. The limit of their proposal is that it does not outline a gradual path for attributing responsibility for the European fiscal stance to the MEF. A simpler and - at the same time - more effective compromise ground consists in ensuring that the MEF, outlined by the European Commission and by France, presupposes strengthened forms of central control of national public budgets, capable of ensuring structural macroeconomic and macrofiscal adjustments ( as required by Germany).
This explains why the possible compromise between Germany and France on governance and fiscal policy brings out a much more substantial divergence between Germany and Italy (along with other fragile member states of the EMU). Germany is certainly worried by the fact that the French public budget has recorded – for many years – a negative balance exceeding 3% of GDP; and it is not certain that, for the current year, this balance will fall below the critical threshold as promised by Macron. Yet the decisive obstacle, which pushes Germany to view the process of building a French-style MEF with suspicion, is represented by the huge Italian public debt and the inadequacy of the structural adjustments implemented. Moreover, this specter is aggravated by the radical political-institutional uncertainty present in our country today.
The most recent forecasts from the International Monetary Fund and the Bank of Italy indicate that the Italian economy has coupled, albeit with a delay, to stronger than expected growth in the Euro-area. Even if Italy's expected growth rate remains significantly lower than the average for the area, it is based on domestic aggregate demand and – in particular – on the recovery of investments by private companies. If these data are reproduced in the coming quarters, Italy will enjoy a non-ephemeral expansionary prospect. This opens a window to launch a credible and balanced path to reduce the public debt/GDP ratio, capable of reassuring European partners about the sustainability of our public debt.
From a strictly accounting point of view, the sustainability of a given country's public debt is guaranteed by a very simple condition: the creation of a primary surplus sufficient to stabilize or reduce the public debt/GDP ratio. It is evident that the level of this surplus depends on various factors and, in particular, on: the average nominal interest rate paid on the public debt, the nominal growth rate of the economy, the past stock of public debt. If the 'real' growth rate of the economy and/or the inflation rate are very low or the stock of outstanding debt is very high, even nominal interest rates that are not exorbitant can make a public budget unsustainable. In those cases, the stabilization of the public debt would in fact require primary surpluses so high as to be incompatible with tolerable levels of taxation, social protection, investment and public services. Since the end of 2015, the structure of nominal interest rates in the euro area has reached historic lows thanks to the forms of QE implemented by the ECB. Yet, also due to the very modest growth rates achieved by our economy, in the same years the Italian public debt/GDP ratio did not stop growing, albeit at decreasing growth rates.
The gradual affirmation of a French MEF model, which incorporates structural adjustments of public budgets in serious imbalance, is in the interest of the Euro-area and of Italy; it is, in fact, the necessary condition to consolidate European growth rates and start a convergence in the macroeconomic fundamentals of the member states. In order for this condition to be achievable, however, there can be no doubts about the present and expected sustainability of the Italian public debt. Consequently, taking advantage of the expected strengthening of the growth rate of our economy, the Italian government should initiate progressive, but continuous and systematic reductions in the public debt/GDP ratio.
In this perspective, the repeated recourse to derogations from European rules, which finds a hearing in the Commission due to the threatened exacerbation of the country's political-institutional instability, is dangerous for Italy. Even worse would be the attempt to reduce the stock of Italian debt by accounting means, ie through processes of formal disposal of part of the public assets to companies with full public control but outside the perimeter of the Public Administration; or to eliminate the accounting weight of loss-making public services, excluding them from the perimeter of the Public Administration. Such expedients would have the effect of accentuating the distrust of European partners and market lenders of the Italian public debt, giving way to dangerous European initiatives to intervene on public debts at risk. In this regard, let us not forget that there is a proposal to create a European Mechanism for the Restructuring of sovereign debt; and that Germany has even hypothesized an automatic mechanism for restructuring the public debt of any member state that requests financial assistance from the ESM.
By exploiting the latest phase of QE and low nominal interest rates, Italy must instead activate a path to reduce its public debt/GDP ratio which, without suffocating the recent recovery, is capable of ensuring adequate growth rates in the medium term and is compatible with the Franco-German compromise. It's not just about reducing the numerator (amount of debt) or increasing the denominator (GDP) in the short run. Instead, it is a question of implementing the reforms recommended by the European Commission and approved by the Council of the EU. In this perspective, it is above all necessary to recompose expenditure and strengthen growth potential; which requires, among other things, the relaunch of efficient public investments and the activation of income redistribution policies and the inclusion of the most vulnerable segments of the population. Furthermore, it is a question of overcoming the persistent weaknesses of the Italian economy which could have a direct negative impact on the public budget. Following the indications of the blue print that the European Commission is preparing to publish on the subject of national bad banks on the basis of what was stated in the conclusions of the EU Council of 11 July, the Italian government must ensure that the banking sector disposes of the persistent excess of problem credits. It is also necessary for this same sector to stop holding an excessive stock of national public debt securities on its balance sheets in a phase of rising interest rates.
The difficulties for a credible implementation of such initiatives are, in themselves, high. The challenge is made even more difficult by the current political-institutional uncertainty and by the expected – even if not immediate – rise in the structure of nominal market interest rates. Yet there are no alternatives. To ensure robust growth rates in the medium term and not to be the weak link in the new European governance, Italy must make its public debt sustainable and correct its greatest weaknesses, using the window of opportunity offered by the temporary continuation of QE and the European recovery. The reduction of the public debt/GDP ratio could also indirectly ease some problems in the Italian banking sector. This reduction would allow the MEF to be entrusted with the design and management of European safe bonds (ESBs) along the lines proposed in the aforementioned Reflection paper of the European Commission (March 2017); and this would facilitate the exchange between these BSEs and the excess stock of Italian public debt securities on banks' balance sheets.
A part of the Italian ruling class and political-institutional exponents does not seem to share the conclusions just reached. Concerns about the sustainability of the Italian public debt tend, in fact, to be treated as unfounded alarmism. An emblematic example is offered by the proposal of Matteo Renzi, secretary of the largest government party: to increase the Italian public deficit, bringing it close to the maximum threshold of the old "Stability and Growth Pact" (2,9% of GDP) for five years ; at the same time, achieve a reduction in our public debt-to-GDP ratio. Neglect the futility of substantiating the proposal with a threatened veto by Italy on the transformation of the so-called "Fiscal Compact" into a European treaty. Two facts remain. First: in a cyclical phase such as the current one, characterized by the robust growth of most of the countries of the Euro-area and by the positive (albeit more modest) growth of Italy itself, the constraints on the structural ratio between public deficit and GDP, imposed by the European rules of the Six Pack, are much more stringent than the nominal constraint of 3% in the public deficit/GDP ratio. Pursuing a deficit just below 3% would therefore constitute a highly pro-cyclical policy. Second: with current growth rates, it is unrealistic to assume that in Italy a public deficit equal to 2,9% of GDP is compatible with the reduction of the public debt/GDP ratio without extraordinary operations on the stock of the same debt.
It is worth dwelling on this last fact. A trivial calculation shows that, with a public deficit of 2,9% and with current nominal interest rates, Italy would comply with the European public debt reduction rules only if it achieved a slightly lower nominal GDP growth rate to 5% on average over the next five years. Given the current Italian rate of inflation, the expected real rate of growth of our economy, while positive, would therefore be less than half of that required. To this should be added that, again in the next five years, a rise in the structure of interest rates is highly probable which will more than compensate for a possible increase in inflation rates. On the other hand, again assuming public deficits of 2,9% for the next five years, the mere stabilization (not the reduction) of the Italian public debt-to-GDP ratio at the current abnormal levels (more than 133% of ) would require annual rates of nominal growth of the Italian economy systematically higher than 2%. Given the low dynamics of expected inflation, even these rates appear unrealistic. A fortiori, it is therefore unrealistic to assume that the public deficit of 2,9% is compatible with a significant reduction in the public debt-to-GDP ratio without extraordinary operations.
To make the reduction of the public debt/GDP ratio compatible with an annual public deficit of 2,9%, extraordinary public debt reduction operations would therefore become necessary. We exclude those purely accounting interventions, which have already been mentioned, because they do not conform to the objective of making the Italian adjustment process credible in the eyes of both France and Germany and the European institutions. It would therefore be a question of resorting to the systematic privatization of publicly owned companies and the disposal of parts of the public assets. If carried out without an industrial policy and territorial sustainability plan and before having started a persistent process of reducing the ratio between public debt and GDP, these operations would however risk producing two negative effects: weakening the already fragile productive and environmental fabric of the country ; disperse the remaining public capital resources without a structural rebalancing of the budget.
The example given proves that Italy's political-institutional uncertainty increases the risk of jeopardizing the medium-term sustainability of our public debt for electoral purposes. This would not be a good way to ensure that Italy can achieve robust growth rates in the medium term and can play a positive role in the construction of that agreement between Germany and France aimed at building the MEF, i.e. aimed at opening the process of fiscal union which is necessary for the future prosperity of the EMU. It is therefore necessary that, taking advantage of the window of opportunity opened up by the more positive economic situation and by the presence of QE, our government starts a credible process of reducing the public debt-to-GDP ratio. To this end, it is a question of: rationalizing the composition of public expenditure; set aside unrealistic tax reduction goals, to instead pursue a tax reform capable of redefining the related charges; increase the growth potential of the Italian economy through efficient public investment projects, financed - as far as possible - from European resources, and through effective incentives for private investment capable of supporting the dynamics of the various forms of productivity.
It is a difficult bet to win especially in a pre-election phase. However, it is the inevitable condition for obtaining two results: making Italian economic growth more robust with respect to negative exogenous shocks and, therefore, with a medium-term outlook; acquire a relevant position in the construction site, which France and Germany are opening along the lines suggested by the Report of the Five Presidents and by the European Commission. Contrary to what a part of the Italian ruling class may perhaps think, this time the defense of Italian positions of income will guarantee neither shortcuts for growth nor a free front row seat for the European party.
