If one distances himself from today's debate on Europe, particularly in Germany, what at first sight appears to be a technical discussion of economic and financial policies takes the form of a demonstration of cognitive dissonance, in particular confirmation bias.
In the words of the Nobel Thaler, the mind of a "human", not of an "econ", as perfectly rational homo economicus calls it, does not accept arguments contrary to its beliefs—what it learned in the family, what it shares with friends. For the Germans, debt is a sin. When they talk about it, the image that comes to mind is the tower in which insolvent debtors were imprisoned. The economics profession is also influenced by this approach. It takes years of study or work abroad to dilute this bias, but fortunately there are these cases.
On the default/debt restructuring of countries with high public debt, a paper written by Blanchard and Zettelmeyer disproves on an empirical and economic theory level all the preventive default proposals for Italy that flourished in this period. The original proposals are from the Bundesbank, which has proposed an automatic default for any country that requests an adjustment program from the European Stability Mechanism (ESM). In other words, transforming it into a European Instability Mechanism: just remember that the European sovereign debt crisis - which delayed the recovery of the Euro Area by 5 years and slowed down growth in the rest of the world, given Europe's weight in world trade - was triggered by the Deauville decision to default on the Greek debt. Playing with default proposals today, having Italy as a target, is irresponsible and above all unfounded. This was confirmed by the director of the ESM, Klaus Regling, who has worked not only in Germany, but also at the IMF, on the basis of studies[i] of the institution he leads and which would be responsible for the adjustment programs of countries in difficulty.
The paper by Blanchard and Zettelmeyer [ii] asks whether the increase in interest rates can lead to new fiscal crises in the current context of a cyclical recovery with low growth in productivity and therefore in potential product, high public debts and populists who propose risky economic policies. The answer is that there is not too much to worry about raising interest rates for 3 reasons: first, because the rate hike will be gradual giving governments time to prepare; second, sovereign debt maturity – which determines when rising interest rates will result in higher interest payments – has increased in this period of low long-term interest rates. In Italy in 2017 debt for only 10% of GDP matures and for 14% of GDP in 2018. Considering an increase of 200 basis points, only 0,5% of GDP would have to be paid more in interest in two years . Third, Italy's debt will remain sustainable because interest rate hikes will occur when economic conditions in Europe improve steadily, so the denominator of the debt-to-GDP ratio will also increase. A very different case from the previous one in 2011 when the financial crisis still had to be absorbed and the prospects of Greek default were fueling the European sovereign debt crisis.
Blanchard and Zettelmeyer put Italian debt to the test in a crisis scenario and a panic scenario: if growth in Italy continued to be much lower than in Europe, a gap would open between interest rates and growth which could make the debt unsustainable and raise the specter of default, causing spreads to soar. But we don't see why Italy shouldn't grow with the output gap it has, far greater than Germany, and having sorted out the banking problems and therefore the credit supply. Even in a panic scenario with loss of access to the market, today there is the ESM whose adjustment program gives access to the "Draghi's bazooka" or the OMT program which causes the ECB to intervene directly on the Italian bond market. Obviously, no one would like to repeat the Greek experience in which the adjustment was not sustainable and the default was still reached. But the Italian situation is incomparably better than the Greek (and Japanese) one. The chart below shows the change needed in Italy's primary fiscal balance to stabilize the debt, given today's primary balance and the output gap, and considering three different increases in public debt yields. The difference with the case of Greece in 2010 and also that of Japan today is enormous. Considering borrowing costs at 2% and a long-term potential growth equal to 0.85%, the adjustment would be zero, with an increase to 3% it would be 1,5% of GDP. Nothing to worry about.
The reason is that Italy has done its homework! And it has a positive primary balance of 1,4% of GDP, while Greece had a deficit of 10% of GDP. So an adjustment program for Italy should focus on growth measures and would not be at risk of default. Unfortunately, these data are not known to the German public and, it seems, not even to some German, French and Italian economists.
However, these scenarios do not include the political risk of populists with irresponsible economic agendas. But in this case the authors say there are no quantifiable scenarios and "any bet is good."
[i] PIIE, Is Europe Prepared for the Next Crisis? October 2017
[ii] PIIE Policy Briefings: Will Rising Interest Rates Lead to Fiscal Crises? Olivier J. Blanchard and Jeromin Zettelmeyer July 2017
