Leave Italy alone: The EU wants fiscal austerity in a sinking economy

• Instead of lashing out at countries systematically destabilizing the euro with their selfish and excessive trade surpluses, the EU is attacking Italy for its attempt to rescue the economy.
• Italy should “keep calm and carry on” with its modest fiscal prop to growth and employment.
• Italy has been at the center of Europe’s epochal project of unity, peace and prosperity – and you can bet the ranch that it will remain there.

Tony Gentile | Reuters

The Italian flag waves over the Quirinal Palace in Rome, Italy May 30, 2018.

A ridiculously ferocious attack on Italy's mildly supportive fiscal policies in the next year's budget are firing up market panic and an unedifying spectacle of chronically mismanaged intra-European relations.

The acrimony leading up to the Italian budget review by the EU Commission has already saddled the Italian taxpayers with an unnecessary increase of their debt burden for generations to come. Only over the last two months, an already high cost of the government's 10-year loans has gone up by more than 100 basis points — a serious blow to a country carrying 2.4 trillion euro ($2.8 trillion) in public debt liabilities. That debt is roughly equivalent to 150 percent of Italy's gross domestic product.

Here is the problem facing the Italian government.

Deprived of an independent monetary policy to manage demand and employment, Italy has slightly reversed its restrictive fiscal stance to provide some support to economic activity and prevent what clearly looks like an incipient cyclical downturn of unknown amplitude and duration.

The country's economic growth in the second quarter of this year continued to weaken, barely eking out a 0.2 percent increase from an already sluggish pace at the beginning of the year. With the exception of exports, all major demand components look weak.

Pro-cyclical fiscal austerity is lunacy

Household consumption — nearly two-thirds of the GDP — is held back by high unemployment and no real income gains. The volume of retail sales in the first seven months of this year declined at an annual rate of 0.7 percent, owing to stagnant real wages and the third-largest (after Greece and Spain) unemployment rate in the euro area.

Last August, 9.7 percent of Italy's labor force was out of work, with an appalling 31 percent of the country's youth without a job and a meaningful future. On top of that, there are 6.5 million of Italians, 11 percent of the total population, living below the poverty line.

Sadly, however, there is even worse: The EU reports that 30 percent of the Italian population is at risk of poverty and social exclusion.

In view of such a poor outlook for domestic demand, some people are wondering whether the suggested German recipe could help. Exports, of course, are the key ingredient of Berlin's nostrum, because they represent 30 percent of the Italian economy.

Alas, that is more of another broken reed and a blatantly manipulative attempt. Over the last three years, net exports shaved 0.5 percent off Italy's quasi stagnant 1.1 percent GDP growth. And while exports in the first seven months of this year increased 4 percent from the year earlier, that did absolutely nothing to revive the country's manufacturing output. The industrial production during the January-to-July period dropped at an annual rate of 0.5 percent.

That, of course, bodes ill for business investments because the weakness in the manufacturing sector indicates plenty of spare production capacity. In other words, Italian businesses need no new machines and bigger factory floors; they already have what they need to meet the current and expected sales demand.

So, what's left to support Italy's jobs and incomes? Nothing — emphatically nothing — keeps screaming the German-run EU: Italy has no independent monetary policy, and, according to the EU Commission, the fiscal stance should remain frozen in a restrictive mode of indefinite duration.

Italy's 'whatever-it-takes' moment

Italy knows what that means. Before the onset of the last decade's financial crisis, and the German-imposed fiscal austerity, Italy's budget deficit in 2007 was whittled down to 1.5 percent of GDP (compared to nearly 3 percent of GDP in France), the primary budget surplus (budget before interest charges on public debt) was driven up to 1.7 percent of GDP, helping to bring down the public debt to 112 percent of GDP from an annual average of 117 percent in the previous six years.

But then all hell broke loose once the Germans — defiantly rejecting Washington's call to reason — set out to teach a lesson to "fiscal miscreants" by imposing austerity policies on the euro area's sinking economies.

Italy should never allow that to happen again.

What, then, should Italy do? The answer is simple: Exactly what it says it wants to do in the 2019 budget passed last Thursday by an overwhelming majority in the Senate (61 percent of the votes) and in the Parliament's Lower House (63.4 percent of the votes).

Italy is comfortably within the euro area budget rule. Its projected budget deficit of 2.4 percent of GDP for the next fiscal year is below the 3 percent deficit limit in the monetary union.

So, why all the fuss? Why is it that nobody seems to be objecting to the fact that France and Spain will have larger deficits than Italy?

France has recently raised its next year's deficit estimate to 2.8 percent of GDP from an earlier commitment of 2.6 percent. And that's not the end of the story. Downward growth revisions are still going on, there is no political consensus on what spending to cut, and an increasingly weak and unpopular government may even fail to keep the budget deficit below 3 percent of GDP.

Spain's unstable minority government is struggling with the same problem. The economy is slowing, and Madrid has a long history of overshooting its budget deficit forecasts. This year's deficit, for example, is now expected to hit 2.7 percent of GDP from an earlier official forecast of 2.2 percent. As things now stand, it will be an epic struggle to keep Spain's budget deficit under the 3 percent of GDP limit.

Why is all that being met by a deafening silence from Brussels? Could it be that the EU's leniency toward France and Spain has a lot to do with their lower public debt?

It's possible, but, if that's true, it's a big mistake. Those countries have a lower debt on a worsening budget trend. France's debt accounts for 122 percent of GDP. The French primary budget deficit means that the debt will continue to climb. Spain's public debt is 115 percent of GDP, with virtually no primary budget surpluses to speak of. And both countries are on the way to growing public sector liabilities as a result of widening budget deficits.

No wonder some people are asking: Is the EU's attack on Italy's fiscal policy part of a different agenda? I'll give you a hint below, but that's a story for another day.

Investment thoughts

Fiscal austerity in a slowing Italian economy — beset by high unemployment, rising poverty and crumbling infrastructure — would be sheer lunacy.

The room for fiscal relief is very small, but this is Italy's "whatever-it-takes" moment: Rome must support its economic activity, employment growth and infrastructure spending.

Italy's government leaders may not like some of their neighbors, but that's not the reason to denigrate the EU. Italians did not give them their votes for that.

The EU's founding fathers — Alcide de Gasperi and Altiero Spinelli — put Italy where it belongs. Greece and Italy are the cradle of the European civilization.

The European unification process has brought peace, a huge and increasingly homogeneous single market, the euro and the European Central Bank — arguably the greatest achievements in Europe's post-World War II history. It's a safe bet that Italy wants to remain at the center of that epochal project.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.