Europe: Italy’s call for a stimulus – structural reform trade-off will happen

Summary: Backloaded austerity is the defining paradigm at work in Europe right now. Italian Prime Minister Enrico Letta has called for this paradigm to be bolstered by fiscal stimulus incentives as a quid pro quo for structural reform. I believe he will get his wish.

The editorial by Enrico Letta which ran today in Project Syndicate is important regarding the policy debate in Europe. The headline reads “Europe’s Responsible Solidarity” but I think the clear message is that in Europe responsible solidarity means a quid pro quo of reform for stimulus.

“if we are serious about the need to support structural reform in member states, greater surveillance and policy coordination must be matched by a system of limited and targeted financial incentives. These incentives can expand the range of options for governments struggling with fiscal consolidation and provide a signal to the European public that the EU is a partner supporting their countries’ reform efforts.”

Letta also spoke of giving more countercyclical fiscal authority to the EU level as well as coordinating regulation at that level. However, I want to concentrate on the stimulus idea here. Letta’s intervention is likely to be crucial in shifting the European policy debate because Europe has already moved to a backloaded austerity paradigm and Germany’s leftward coalition shift will welcome this policy initiative.

The move to back-loading in Europe

Let me briefly review how we got here in order to help demonstrate why this is a logical step forward for Europe. Early in the year, the situation in Europe was poor and deteriorating. If you recall, I was running through unilateral Cyprus exit scenarios in March and people were very concerned about contagion from Cyprus wrecking the whole of Europe. It seems a long time ago now but the situation was pretty dire at the time.

While things have improved since then, the prevailing economic paradigm in Europe has not changed. It is a three-pronged approach regarding crisis consisting of maintaining sustainable public finances, aiding countries in need through common European mechanisms like the EFSF, and ensuring adequate capitalization of the banking system (outline here from April). This means austerity and bailouts for countries on an unsustainable fiscal path plus bank recapitalization all around where necessary. The Cyprus example was a test bed for all three points on this macro outline.

Amazingly, the Cyprus response including the bank depositor bail-in worked to calm the markets in large part because European policy makers moved toward a more relaxed stance on fiscal consolidation in the immediate aftermath of Cyprus. In April I outlined why austerity in Europe will continue and added more on back-loaded austerity to emphasize how the lack of social and political stability in the periphery was forcing a shift in rhetoric and policy. I highly recommend reading Olivier Blanchard and Daniel Leigh’s piece that outlines why Europe is moving to backloading austerity; it sums up the economic and political thesis quite well.

At the same time, electoral politics in Europe meant Germany was moving in this same dovish direction. I first outlined this in January. However, in retrospect, it is comments by European Commission President Barroso from May that make the most sense in revealing the policy shift. If you recall, Barroso was caught out by Wall Street Journal journalist Marina Stevis talking unfavourably about the impact of front-loaded austerity on the periphery. The bluntness of his anti-austerity commentary caused a furore. I sensed this as an over-reaction because Barroso was fully in support of austerity as I wrote in my piece on more on back-loaded austerity referenced in the paragraph above. Later, in May Barroso came out and said this directly in an interview with a German newspaper. The quote of note was : “Merkel knows best what’s happening in Europe”. I wrote: “what Barroso said in that interview was that Germany has acted. He said that Merkel was one of the European leaders who best understood what is happening in Europe. He said Germany is deeply invested in the European project and that it has not selected the lead role in the crisis but has been pushed into it.

“My translation of these events, therefore, is that austerity is being lessened in order to accommodate the facts on the ground not because of some grand ideological transformation of European policy makers. Ideologically, it is the same as it ever was: the crisis is the result of profligacy, lost competitiveness and speculation. Ergo, the solution will be austerity, internal devaluation and better financial regulation. And this will continue to be the case, the pace of reform slowed only because social and political opposition. Austerity will continue.”

Within days Europe was officially in back-loaded austerity mode – where it will stay. Thus, my view has been validated.

The move to stimulus as a quid pro quo for structural reforms

Since the move to back-loading, Europe’s sinking economy had turned up so much by August that I wrote how my updated European macro outlook for 2013 is positive where it has remained (despite some weak data out of the periphery). But it is not nearly good enough for us to think this crisis is over.

Therefore, the larger periphery economies of Spain and Italy matter a lot, along with France because of weakness there. Marc Chandler argues that Italy is the weak link in Europe and I think his analysis makes sense both economically and politically. And so Enrico Letta is a very important figure. Here’s what I wrote on the Italian Prime Minister’s view of austerity in April when he came to power (emphasis added):

Letta is talking about backloaded austerity with relaxed timetables and structural reforms. Until we see real growth agendas being developed instead of tinkering at the margins and talk of structural reform, backloaded austerity is not going to be a pro-growth policy evolution. It is austerity lite and that’s it. And I think this is as far as Europe is prepared to move at this time.


I believe Spain and Italy are near the breaking point, meaning the countries will throw off the austerity yoke if conditions deteriorate much further. But France and the Netherlands are also in peril and would support this if the situation in Spain and Italy is dire enough and the situation in France and the Netherlands has deteriorated….

As for Italy, the numbers are not looking good, particularly in terms of credit growth and credit quality. Non-performing loans are increasing to an alarming level. And this is telling you that bank bailouts may be coming unless Italy can turn toward growth. The Italian government cannot afford to bail out any large financial institutions without significant private creditor participation. And even then any socialization of losses could move the Italians into OMT territory. Moody’s is now saying Italy may eventually need a bailout. And this would certainly be true if we get a bank crisis in Italy due to rising NPLs.

So, the pressure is on for a pro-growth agenda. Right now we are only getting a relaxation of targets. Even the OECD supports the targets being relaxed. And the rumour is that Italy could officially ask to be removed from the EU’s excessive deficit monitoring list as soon as next month. This would in effect allow Italy to pursue whatever fiscal policy it wants. And could mean Italy turns pro-growth very soon.


…If Italy can get itself off the excessive deficit list, it can move to a pro-growth agenda while still nominally talking of making specific deficit targets. Stimulus would even be possible.

So, that’s indeed where we have come. Letta’s intervention in an English-language forum is telling the world that he wants the backloaded-paradigm to officially support stimulus.

I think this call is likely to succeed. The key reason is Germany. Going back to Barroso’s comments from May, clearly Barroso was saying effectively that he and Merkel were on the same page on policy. She had already shifted toward ECB interventionism in marked disagreement with the German central bank. Now, here was Barroso telling you that she was going to give backloaded austerity a green light. So forget the rhetoric. Merkel has been saying, post-election that austerity needs to be maintained. Of course, she is going to say that because that is what the German electorate wants to hear. However, if you look at the implications of the German elections for the economy and markets, Merekl has to form a government coalition with a left wing party in Germany – most likely the SPD. I believe she will be open to this idea of targeted fiscal stimulus incentives in conjunction with backloaded austerity and structural reform for just this reason as the SPD has already voiced support for it in the past. I think this is where Europe is now headed and Letta’s piece is the first sign that this agenda will move forward. As I put it in April:

“The crisis in Europe is far from over. And I do not believe there has been any paradigm shift in policy response. We will continue down the path of bailouts in exchange for austerity that began three years ago with the first bailout for Greece. But now two factors have been added to the mix. Austerity will be leavened by actual stimulus to create jobs and capital investment, not just structural reform policy. Spain and Portugal both are presenting budgets with this in mind, measures which will cause their targets to be pushed back. I believe these policies will be approved at the EU level too, marking the only real break in the austerity paradigm.

“On the bailout side, bail-ins will take center stage. There is no fiscal space or political appetite for more bailouts, even of the loan and guarantee variety. Every single crisis flashpoint from here on out will be met with private sector losses. The only question now is where crisis crops up next. While I had been tipping for Spain early in the year, I believe Slovenia is where crisis is headed next. And given the country’s small size, it will be interesting to see, how far policy European policy makers are willing to deviate from previous policy positions to deal with this crisis. This is only months, if not weeks away. Stay tuned.”

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