The Great Unequalizer
The Pandemic Is Compounding Disparities in Income, Wealth, and Opportunity
Thirty years ago, two Italian economists, Francesco Giavazzi and Marco Pagano, published a paper explaining why governments would bind themselves to international economic agreements that constrain their policy choices. External constraint, they argued, was the price for credibility. By tying their own hands, policymakers communicated to markets that they were committed to responsible but painful and potentially unpopular policies. And by shaping market expectations, policymakers made it easier and less costly to achieve their own domestic goals.
For roughly two decades, running from the late 1980s until the start of the global financial crisis in 2008–09, Italian policymakers have used that notion of external constraint—in Italian, vincolo esterno—to introduce substantial reforms to pensions, labor markets, and government finances. As prime minister, Romano Prodi even used vincolo esterno to help Italy meet the requirements to join the euro.
Yet Italy’s new government, an alliance between the left-wing populist Five Star Movement (M5S) and the right-wing populist Lega, has declared an end to this kind of signaling by constraint. Their goal, outlined in a 58-page document covering everything from agricultural policy to university education, is to make reforms without international commitments. Italy’s hands won’t be bound anymore.
The problem is that the international constraints agreed to by previous governments have not gone away. Rome remains enmeshed in EU procedures for macroeconomic policy coordination, which require it to cut its debt and deficit and reform other economic institutions. Furthermore, Italy is more dependent upon markets now than ever before. If markets suddenly change their expectations about Italy—if they believe that the new government will not abide by the commitments of previous ones—borrowing will become more expensive and policymaking more complicated. Giavazzi and Pagano were right about that.
Italy’s new government has declared an end to signaling by constraint.
The new coalition partners seem not to care. Indeed, they appear eager to demonstrate that they are willing to pay for greater room to maneuver. This desire to throw off vincolo esterno is critical to understanding how the government will approach both the EU and its own domestic reform agenda. It explains why so many of the reforms the coalition is proposing—including those related to pensions, income support, government finances, tax reform, and banking supervision—run against the grain of Italy’s European commitments and why the leaders of the M5S and Lega react so quickly to any European statements about the importance of following the rules (on Tuesday, Lega leader Matteo Salvini warned France against “poking [its] nose into other people’s affairs”).
Most important, this desire to break free of external constraints explains why the composition of the ministerial team is less important than the general commitments sketched in the coalition agreement. Whether the new government appoints an economist or a politician as finance minister, it is going to push back against any attempt by outside actors to force it to rein in its ambitions, which involve revolutionizing how households and businesses are taxed, how illegal immigrants and asylum seekers are handled, and how the Italian welfare state works to support the elderly, the poor, those seeking employment, and those who cannot support themselves.
On Wednesday, after Italian President Sergio Mattarella finally assented to the appointment of Giuseppe Conte as the new prime minister, Salvini quickly announced the government’s priorities for its first three months in office—lowering taxes and rolling back unpopular pension reforms, passed in 2011 under the crisis government headed by Mario Monti. Some of this will be relatively straightforward. The new coalition cannot radically change the Italian tax code in its first hundred days, but it can eliminate some of the excise taxes on gasoline and begin changing the eligibility criteria for pensions, for instance by replacing age requirements with years worked and by allowing women to exit the work force earlier than men.
These sound like modest changes, but they will be expensive. According to estimates by Carlo Cottarelli, the former fiscal affairs director of the International Monetary Fund, eliminating the excise taxes alone will result in more than $7 billion in lost revenues, while the change to pensions will add about $9.4 billion in spending. Over the longer term, moreover, the costs of the pension reforms will only increase as more people age into early eligibility.
In the meantime, the EU is expecting Italy to find another $5.8 billion in savings to meet its fiscal targets for this year and $11.7 billion to avoid an automatic increase in value-added taxes set to take place in January 2019 as part of its EU commitments. Hence it is not enough to look at what the new government is doing in its first hundred days; what it is not doing is also important to take into account.
The gap between the new government’s policies and the EU’s expectations will be evident in the amended economic and financial document that the government has to deliver to the European Commission in September. That document sets out the expected impact of the government’s policies on its fiscal accounts so that the commission can assess whether Italy will meet European rules for limiting debts and deficits. It will be hard to avoid a showdown of sorts if the Italian submission deviates widely from European norms.
The new government seems to want that showdown. Although Mattarella has insisted time and again that any prime minister he nominates should respect Italy’s place in Europe, his influence will diminish significantly once the new government receives a majority in both chambers of the Italian Parliament. That should happen early next week. When it does, the prime minister, not the president, will become responsible for the general program of the government. Many worry that Conte, an obscure law professor with scant experience in politics, will have little autonomy relative to Salvini or Luigi Di Maio, leader of the M5S. The most important constraints on Conte, however, stem from the detailed policies agreed to in the coalition contract, which sets out the program for the new government.
As it stands, that program includes a number of positions that seem tailored to goad some sort of response from Europe. For example, the coalition contract includes a long passage about the pain suffered by ordinary families when Italian banks were restructured or put into resolution in 2015 and 2016, during the premiership of Democratic Party leader Matteo Renzi. The contract promises to find ways to ensure that in the future, families are compensated for any losses they incur as a result of exposure to bank bonds and equity.
Such a commitment flies in the face of repeated Dutch and German insistence that bank investors should share the consequences when bank managers take unnecessary risks. And although northern Europeans are arguing that banks should be limited in their exposure to the sovereign debt issued by their home countries (for fear of government finances and financial stability becoming too closely intertwined), the Italian coalition contract insists that the whole treatment of sovereign debt holdings by banks at the international level needs to be revisited.
There are other examples where the coalition contract shows a willingness to think outside the European box. For instance, it proposes developing very small sovereign debt obligations that can be used as payment for government arrears and then traded by the recipients in secondary markets, which would go a long way toward helping Italy pay for its ambitious policy program. In turn, these bonds could be handed back to the government as payment of tax obligations. This is an interesting way to think about government finances. The problem is that creating small, tradable debt securities that can be used as payment sounds a lot like printing money, which is anathema to the European Central Bank. It is hard to see how either the ECB or the European Commission would stay quiet about such an innovation. It is also hard to see how the new Italian government will pay its bills and meet its new spending commitments without it.
Given that many of the proposals in the government contract are likely to be shot down by the EU, there is a temptation to regard it as some kind of temporary aberration, which will be moderated as Italy is forced to face reality. Many compare the new government with the populist government that came to power in Greece in 2015. Led by the radical-left party Syriza, that government came in rejecting EU austerity measures, and its unorthodox finance minister, Yanis Varoufakis, seemed to relish conflict with his European counterparts. Eventually, however, Syriza accepted the binding nature of the constraints imposed by the EU (as did the people of Greece). The hope is that the new Italian government will learn from the Greek experience rather than force a confrontation with Europe.
The reality is more complicated. Italy’s new coalition is not the first Italian government to abandon the idea that vincolo esterno is necessary for market credibility. From 2008 to 2011, the government led by Silvio Berlusconi pushed back against EU requests for pension reforms and other fiscal consolidation measures while resisting pressure for any kind of international bailout. When Berlusconi finally yielded to the demands of European leaders for more decisive policy action, he was replaced by Monti. The next two governments were less rebellious, but from 2014 to 2016 Renzi became assertive about lifting European constraints on many of the same issues—such as protecting small-bank creditors and refusing caps on how much Italian sovereign debt could be held by Italian banks—that the new coalition government is raising.
The difference this time around is a matter not of tone but of audience. The Renzi government believed in the importance of market credibility and was willing to undertake reforms, such as a “jobs act” providing for more labor market flexibility, in order to demonstrate its competence. The new coalition is less worried about credibility with the markets than about credibility with its own electorate. Italy’s populists have moved beyond vincolo esterno not because they believe external constraint is unnecessary but because they believe it is irrelevant. The question is how much that belief will cost.