Part II – lessons from Italy

In my previous post I presented some arguments against additional deficit spending in Latvia even in the face of low interest rates. Here is an additional argument, which I chose to present in a post of its own not to make the previous one too long. And because it is very important in and by itself by addressing the main problem of government fiscal policy: The tendency for deficit bias.

At first one might argue that Latvia has plenty of scope for additional spending since its government debt, at 36% of GDP, is very low by EU standards, see Figure 1. Actually so low that it is comfortably within the 60% Maastricht criterion, a criterion only fulfilled by 11 of the 28 countries at the moment (up to and including Slovakia).

Figure 1: Government debt as % of GDP, EU28, 2015 (Eurozone countries in red)

Source: Eurostat

But it is also a ratio that can increase fast as was witnessed here in Latvia. With the financial crisis and its ensuing large budget deficits and shrinking GDP, debt-to-GDP rose, see Figure 2, from less than 10% to more than 40% in just three years – ominous by itself.

Figure 2: Latvian government debt as % of GDP, 1995 – 2015

Source: Eurostat

Now, enter Italy. At 132% of GDP Italy has the second-highest level of debt in the EU, only surpassed by Greece; a debt that was built up running large budget deficits in the 1950s, 60s, 70s, 80s, 90s….. The ‘good’ old days when it could inflate some of the debt burden away by printing money – typical government deficit bias: That spending is much preferred to raising revenue. Spending creates jobs and growth in the short run while the pain – inflation, lower real wages and devaluation comes later – and, with luck, even under another government.

With adoption of the euro money printing is of course no longer possible but Italy still suffers from a large debt overhang from the profligate days of the past and this will haunt the country for very many years to come and this poses a lesson for Latvia.

In Figure 3 I looked at IMF data as far back as I could (only 1988). The red columns represent actual budget deficits and it is seen that Italy ran substantial deficits in the 1980s and 1990s before tightening fiscal policy dramatically to meet the 3% deficit Maastricht criterion to enter the Eurozone.

Figure 3: Actual and primary budget balance in Italy, % of GDP, 1988 – 2015

Source: IMF

The green columns represent the so-called primary budget balance, which is the same as the actual budget balance but excluding interest payments on existing debt. It thus represents the “pure” spending and revenues of a certain year – how fiscal policy would have looked like had there been no debt due to past profligacy.

It is seen that Italy typically runs primary surpluses – meaning, in terms of tax revenue versus expenditure, it actually taxes more than it spends – red deficits only appear due to large interest payments. As such, Italian fiscal policy is actually quite tight – in 2015, the most recent year, the difference between red and green is four percentage points, meaning that Italian tax payers have to cough up an extra 4% of GDP just to pay interest on old debt. Was all that debt used for great infrastructure projects that continue to benefit the Italian economy? Rhetorical question, of course….

But financial markets are quite happy with this of course, rewarding Italy with a fairly low interest rate (see previous post) of 1.45%, though much higher than Latvia’s of 0.48%. But this only goes on for as long as Italy delivers green surpluses – otherwise it will go the way of Greece.

Young Italian tax payers can thus look at a whole life where they have to pay more in taxes than they receive from the public sector – just because past generations built up a mountain of debt.

Should this be allowed vis-à-vis young tax payers in Latvia? Yet another rhetorical question, obviously….

Points of view presented here are not necessarily those of the Fiscal Discipline Council.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council of Latvia

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