Overcoming the taboo of monetizing the deficit to save the euro

1. THREE QUESTIONS AND THREE FAILURE

Sixty years after the Treaty of Rome, the achievements of the European integration process, the European Union and the common currency, appear much more fragile than one could have imagined just a few years ago. The growth of anti-European movements throughout Europe is a reality, albeit with a different weight and characteristics, in the main countries of the Eurozone. The victory of the anti-European candidate in the elections for the French presidency is not yet considered probable, but without a doubt the event has moved from the category of the impossible to that of a low degree of probability.

In this context, the questions that need to be answered are at least three, linked together. What are the objective conditions for the survival of the European integration process, in any of the imagined forms, and for avoiding a path of disintegration in the opposite direction? Is the single currency essential in the European plan or is it necessary to prepare for a step backwards? Above all, what to do to strengthen the monetary union?

To understand the significance of the three questions, it is best to start with a diagnosis, namely the three undisputed deadly failures of monetary union, which are naturally accompanied by important successes, which however do not compensate for the first. They are the substantial failure in the process of convergence and elimination of internal macroeconomic imbalances, the failure of the coordination of macroeconomic policies, i.e. between monetary policy and fiscal policy, the consequent failure to correct external imbalances.

The German trade surplus is not compatible with the monetary policy of the ECB and with the requests for macroeconomic coordination with the rest of the world necessary to avoid conflicting solutions. But this surplus is, in turn, also a consequence, as the German authorities have pointed out, of the attempt to use the monetary instrument to support the growth of the Eurozone without being able, at the same time, to correct its internal imbalances.

In fact, the euro implies fixed exchange rates within the eurozone and the exchange rate, like any other price, when it is not free to fluctuate cannot represent an instrument of macroeconomic rebalancing between the member countries. This implies that it is necessary to provide for other rebalancing tools to allow economies to converge and not to diverge.

The three bankruptcies are the result of an economic policy based on an economic and fiscal adjustment strategy which has not led to positive results. Since the 2008 crisis, the eurozone has not grown and has not been able to absorb the unemployment that has arisen. We were told that the objective of internal convergence, i.e. readjustment between weak and strong countries, should be pursued through internal deflation (i.e. the reduction of prices and wages) in the former, and we obtained a general deflation against which with great difficulty fight the ECB.

We were told that fiscal consolidation had to be the key objective to pursue despite the recession, also to force reluctant countries to accept domestic deflation. We obtained deflation but not fiscal consolidation, since public debts continued to grow not only in Italy (recall that the fiscal compact was intended to put the debt/GDP ratio on a downward trajectory).

2. THE GROWTH OF PUBLIC DEBT IN THE EUROZONE

From 2007 to 2016, gross public debt in the eurozone increased by more than 25 percentage points of GDP (from 65,0 to 92,2 percent), despite Germany curbing this aggregate dynamic. In the same period, French public debt increased by 35 percentage points of GDP, Spain's by around 65 points, Portugal's by around 62 points and Italy's by 32 points.

What happened once the acute phase of the crisis that began in 2008 was over? There was no noticeable trend towards happy finance. Over the past five years, the eurozone has always recorded primary budget surpluses overall, and not mainly thanks to Germany. Italy maintained the highest primary surpluses, up to three times the aggregate eurozone surplus, and only France, among the countries that saw their sovereign debt grow the most, recorded primary deficits, albeit limited.

If we look at the overall deficits, however, i.e. gross of interest on the debt, only Italy among the large indebted countries has kept its deficit below the limit of three per cent of GDP, and, according to the estimation methods of the OECD, has also been substantially balanced when adjusted for the cycle for five years. And yet, it is worth remembering that in 2011 the then Italian government in office fell under the imperative of bringing the balanced budget forward to 2013, and today, after six years, Italy is pleased to maintain the deficit in 2017 below 3 percent.

As far as debt is concerned, it should also be noted that from 2008 to 2011, i.e. with the full impact of the crisis, the Italian debt in relation to GDP increased by 14 percentage points, while from 2011 to 2015, in the midst of austerity, it grew by another 16 points, exceeding 132 percent.

A recent study shows, however, how the share of countries that fail to meet the budget targets set at European level has fluctuated over the last twenty years and has decreased since 2009 as regards compliance with the deficit ceiling. On the contrary, non-compliance with the debt rule is steadily increasing: 75 percent of eurozone countries currently do not respect the public debt limit of 60 percent of GDP.

Today the European leadership no longer speaks of austerity, and the term "fiscal consolidation" has been replaced by the more modest "maintenance of rigour". And technically it is true that we are no longer in the ambit of austerity, as European fiscal policy has become slightly expansionary overall. But this does not change the situation because five years of austerity policy has caused a level of atrophy of production capacity which cannot be overcome with a "slightly expansive fiscal policy".

What has been lacking in recent years to limit the destabilizing potential of the debt accumulated throughout the Eurozone is, as is known, the growth of nominal GDP, crushed by the absence of inflation and low growth in real terms. All of this makes the European Union weak and unprepared to face an international context which makes us foresee a much tougher strategic, economic and commercial confrontation than in the past, in which China and the United States will mainly be the protagonists.

In reality it is clear what should be done, but the rules governing monetary union should be changed. It is not easy to change the rules and the path is not that of non-compliance with the rules, even if up to now the Union has gotten along by essentially accepting non-compliance or their flexibility. But in this way Europe is blocked.

We know that a massive public investment program is needed to relaunch European growth on the supply side and on the demand side, but this path is forbidden under European rules for countries that do not have fiscal space, i.e. those that have more need, if not to the very limited extent allowed by the few adjustments still possible between capital expenditure and current expenditure after years of budgetary compression. The answer of those who argue that the fiscal space is further cutting current public spending is not currently an answer. It would be necessary to resort to deficit spending to finance public investments, an action corrected in principle according to the so-called golden rule, which has been talked about at least since the European rules of stability and growth were conceived, but never accepted due to distrust in the correct use of the rule itself by pro-spending governments.

However, beyond the European rules, abundantly violated up to now, as noted above, the real limit to the expansion of sovereign deficits is not the European rules but the further growth that would ensue in debt. It is therefore the potential sovereign debt crisis that weighs on the maneuvering possibilities of governments, especially those of the most indebted countries, whose difficulties would risk becoming systemic, endangering the overall construction of monetary union. This is the real center of the debate in Europe, and in particular with Germany, and the cause of the periodic re-emergence of positions that envisage the possibility that some weak countries (not just Greece) will leave the euro.

3. HOW TO GET OUT OF EXCESSIVE SOVEREIGN DEBTS

Carmen M. Reinhart and Kenneth S. Rogoff (both Harvard University), basing themselves on the historical experience of "exits" from high debts by advanced countries, find that basically they have involved following some combination of five possible paths: 1) economic growth, 2) fiscal adjustment-austerity, 3) explicit (de jure) restructuring or default, 4) unexpected inflation, 5) a continuous dose of financial repression accompanied by inflation.

We have already pointed out that the path of austerity has not worked for the eurozone because it has not combined with that of economic growth and inflation. On the contrary, fiscal adjustment and austerity, even with poor compliance with fiscal targets by most of the eurozone countries, have failed to produce the result of macroeconomic convergence through domestic deflation and have nullified the possible debt reduction action attributable to the first and fourth of the paths mentioned by Reinhart and Rogoff.

What contributed to curbing the growth of debt was only monetary policy which led to a certain amount of "financial repression", keeping interest rates low and therefore redistributing income between debtors and savers, something not appreciated by Germany and by all European savers, but without achieving the level of inflation necessary to produce significant effects.

According to the aforementioned classification, what theoretically remains to be followed is the path of debt restructuring and more or less explicit default. And it is this specter that makes negotiations to change the conduct of European budgetary policies rather difficult and that fuels the fear of a new strong financial instability that would pave the way for traumatic solutions. A specter that also makes it difficult to talk about leaving the euro.

On the other hand, it is a specter that cannot be pretended to be just a German fantasy, even if the sustainability of the high Italian debt is not in question, at least until it is confirmed in the subjective sentiment of financial operators as well as in the estimates of international bodies.

In fact, the amount of sovereign debts is the real problem under European rules, ever since the European reaction to the Greek sovereign debt crisis in 2011 made it clear to everyone that the convergence of interest rates in the Eurozone until then did not depend on the sudden leveling of country risk among its members, but from the fact that it had forgotten that national debts are not covered by the European umbrella.

The inability to deal with an objectively limited crisis made the markets recover their memory and triggered a deeper crisis by showing the flaws in the construction of the euro, then partially and provisionally plugged by the action of the ECB with an interpretation, according to some , perhaps too creative, even if necessary, of one's goals and limits of action.

The debt accumulated in Italy in the last century, and then increased in most of Europe starting from the 2008 crisis, is therefore not only the boulder on the road to a serious growth policy but also represents the element that would make it very complicated also an agreed or non-agreed exit from the euro.

The alternative is to reactivate the road to economic growth associated with higher inflation and, realistically, even a little financial repression. But this requires loosening the causal link between public spending, albeit for investments, deficits and debt.

4. THE ROLE OF PUBLIC INVESTMENT

There is broad agreement of opinions on the fact that what is missing from the appeal are the investments necessary to support internal demand in the Eurozone but above all to recover competitiveness on international markets and to ensure the long-term, above all social, sustainability of growth.

The Junker plan, which was to represent the second pillar, alongside the monetary policy of quantitative easing, of European economic policy does not appear to be a sufficient response so far. The monetary policy, albeit aggressive, was unable to adequately support private investment. The speed and depth of technological innovation, and above all the speed with which it spreads, if on the one hand they open up great investment and success opportunities on the other, they also seem to represent an element that discourages private investment for the high level risk of operating in globalized markets.

Hence the opinion that the crucial component of growth that is missing are public investments, which have fallen sharply in all countries, and therefore the gap in the quantity and quality of the public capital stock in fundamental sectors for the return on the stock of private capital, especially in the most innovative sectors in which the space for future growth will be concentrated, from ICT infrastructures to the green economy. Just think of the massive investments in training that are necessary for what, with a somewhat imaginative but synthetic terminology, is used to define "Industry 4.0" and to develop the tangible and intangible infrastructures necessary for it. This is not just an Italian problem.

5. A CASH-FINANCED TAX STIMULUS AS A DEBT OUTPUT

Much of the Eurozone, and certainly Italy, needs a fiscal stimulus of much larger dimensions than those under discussion in the rosiest of interpretations of flexibility. It is necessary that the "whatever it takes" is extended from monetary policy to fiscal policy. Fiscal stimulus must, however, consist of substantial public deficit investment programs.

And it's not a question of digging and filling holes to support demand, but of bridging a deep and prolonged fall in investment that is compromising the productivity and competitiveness of the European economy in the present and in the future. Therefore, a public investment program is needed, financed in deficit because this also serves to relaunch domestic demand, since governments cannot force private individuals to invest, but can and must create the prospects so that it becomes convenient to do so.

Naturally, all of this implies addressing the real question that has blocked European economic policy in recent years: how to reconcile the necessary fiscal stimulus with the danger, or the near certainty, that the further growth of public debts will create further distrust in their sustainability.

The only strategy that under the conditions described seems possible, as well as necessary, is therefore that of a fiscal stimulus financed through the creation of money. In other words, what is proposed is the monetization of a part of the public deficit, intended to finance without creating additional debt a large and generalized program of public investments, with the constraint of maintaining a structural primary surplus net of this financing , obtained through the control of current spending to an extent compatible with a path of constant debt reduction.

The objective is to reduce the debt/GDP ratio by operating on the two terms of the ratio: stimulating real GDP growth and at the same time determining the reduction of nominal debt by stabilizing the primary surplus, net of monetary financing.

A few simple calculations for Italy show that with an average cost of debt contained within 3,5 per cent (today it is slightly lower), a nominal growth rate of at least 3 per cent and a primary surplus maintained above 2 per cent (today it is slightly lower), the debt/GDP ratio would be put on a path of stable, albeit still slow, decline.

Considering, however, that the cyclically adjusted Italian primary surplus is estimated by the OECD to be higher than 3 per cent, it can be hypothesized that the boost of a monetary-financed investment program could lead to the Italian primary surplus, as a consequence of the reduction of the output gap, close to this level without scuppering growth.

Without the assumed monetary-financed fiscal stimulus, a continued primary surplus above 3 percent would be unsustainable under current output gap conditions.

The fiscal stimulus should obviously be temporary and uniformly guaranteed to the entire eurozone, whose public debt is overall just under 10 trillion euros. The monetary financing of a public investment program of between 2-3 per cent of eurozone GDP would cost 200-300 billion a year, a figure well below the amount produced with quantitative easing, even in the now reduced version of 60 billion monthly.

The share of financing that Italy would benefit from in proportion to GDP would be between 30 and 45 billion a year. In the Eurozone as a whole, with a nominal GDP growth rate that could steadily go well beyond 4 per cent a year (we are already around 3 per cent), and an average cost of debt stabilized at around 2,5 per cent cent, the entire Eurozone would enter into a perspective of debt reduction, stabilizing the expectations of the international markets.

It is hoped that the objections to this policy will not be reduced to the observation that the current rules do not allow it, because by now it is established that the current rules, without a "whatever it takes" that is applied simultaneously to fiscal as well as monetary policy, they lead to European dissolution and only fuel proposals, of various kinds, to abandon the euro.

On the other hand, the traditional objections themselves to such an option appear questionable in the current economic context. The inflationary impact appears to be a minor issue under current conditions, as we are facing a demand deficit and central banks around the world have flooded the markets with liquidity, unsuccessfully trying to raise inflation and keep it low. the value of their respective currencies.

A revival of growth would probably favor an increase in inflation, and therefore the desired increase in nominal GDP. In part, this could also be reflected in nominal interest rates and therefore translate into a higher debt burden, but the effect could be limited because the program would reduce the risk associated with the sovereign debts of all eurozone countries in a context of greater growth and recovery of competitiveness by strengthening debt sustainability.

In any case, a reduction of the financial repression mechanism that is currently fueling the "populist" revolts of savers would be positive.

 As for the relaxation of the fiscal customs of the Mediterranean countries that such a policy would encourage - a typical German obsession - it suffices to remember not only that in Italy, as already underlined, the primary surplus in relation to GDP has been higher for at least twenty years than those of the major countries of the eurozone including the German one, but also that the hypothesized program should be linked to the maintenance of a balanced structural budget net of the monetary financing of investment spending.

6. A LOOK AT HISTORY

Italy has benefited from a "real" historical simulation of the rule relating to the non-currency financing of the public deficit, a rule today considered inviolable but which on the contrary must be handled with care. The so-called divorce between the Bank of Italy and the Treasury in 1981, which interrupted the monetary financing of the Italian public deficit, led to the doubling of the public debt in a decade.

Naturally, the causes were various, among which mainly the failure to change the mechanisms of public expenditure until the 1992 crisis, when the primary surplus became positive for the first time. However, this bears witness to the limits of strategies based substantially on the thaumaturgical effect of external constraints, an idea that dies hard.

In reality, pursuing the objective of reducing inflation and stabilizing the exchange rate, without preventive correction of the dynamics of public spending, led to a rapid increase in real rates on debt together with the progressive growth of the share of the deficit financed with debt, and then its explosion.

Indeed, net borrowing remained consistently above 11 percent of GDP until 1992, but interest on debt rose from about 5 percent of GDP in 1981 to 11 percent in 4. And it has been since then. that Italy travels with a lead ball at its foot. The 1992 crisis extended this situation to many eurozone countries and it is perhaps time to address the problem.