{"id":59123,"date":"2011-11-09T11:03:36","date_gmt":"2011-11-09T00:03:36","guid":{"rendered":"http:\/\/www.fnarena.com\/index.php\/2011\/11\/09\/italy-credibility-is-not-everything\/"},"modified":"2011-11-09T11:03:36","modified_gmt":"2011-11-09T00:03:36","slug":"italy-credibility-is-not-everything","status":"publish","type":"post","link":"https:\/\/staging.fnarena.com\/index.php\/2011\/11\/09\/italy-credibility-is-not-everything\/","title":{"rendered":"Italy: Credibility Is Not Everything"},"content":{"rendered":"<p>\n\tBy Paolo <span class=\"scayt-misspell\">Manasse<\/span>, Professor of Macroeconomics and International Economic Policy at the University of Bologna<\/p>\n<p>\n\t<em>UPDATED: Changes in the Italian government are driven by the country&rsquo;s dire debt situation. This column, which updates a 31 October column that illustrated the <span class=\"scayt-misspell\">unsustainability<\/span> of Italian debt, argues that <span class=\"scayt-misspell\">Berlusconi&rsquo;s<\/span> departure is necessary but far from sufficient. Drastic, but evenly distributed measures of consolidation and reform are necessary<\/em>.<\/p>\n<p>\n\tFinally, <span class=\"scayt-misspell\">Berlusconi&rsquo;s<\/span> time seems to be over. A slow, but seemingly unstoppable landslide of <span class=\"scayt-misspell\">rightwing<\/span> MPs to the <span class=\"scayt-misspell\">centre-left<\/span> opposition is making it very likely that, next Tuesday, the government will lose its majority in a crucial parliamentary vote on the Stability Law. He may even resign before the vote.&nbsp;<\/p>\n<p>\n\tResigning early would not just be to avoid a shameful dethroning (Mr. <span class=\"scayt-misspell\">Berlusconi&rsquo;s<\/span> penchant for shameless <span class=\"scayt-misspell\">behaviour<\/span> is notorious), it would give him leverage when it comes to crowning his successor. Resignation might also facilitate an eventual resurrection in due time.<\/p>\n<ul>\n<li>\n\t\tIf one of the Prime Minister&rsquo;s straw men, such as Under Secretary Mr. Letter (a journalist and former employee of <span class=\"scayt-misspell\">Berlusconi<\/span>), succeeds his mentor, nothing will change and Italy will be doomed.<\/li>\n<li>\n\t\tThe alternative, seemingly <span class=\"scayt-misspell\">favoured<\/span> by President Napolitano, would be a <span class=\"scayt-misspell\">centre-right<\/span> <span class=\"scayt-misspell\">centre-left<\/span> Greek style coalition headed by Mr. <span class=\"scayt-misspell\">Monti<\/span>.<\/li>\n<\/ul>\n<p>\n\tA wise economist of international reputation and no political ambitions, he may succeed into forcing a recalcitrant Parliament (<span class=\"scayt-misspell\">apr&egrave;s<\/span> <span class=\"scayt-misspell\">moi<\/span> le deluge) into approving drastic, but evenly-distributed consolidation and reform measures, and lead the country to new elections next year.<\/p>\n<p>\n\tAs I wrote in my 31 October 2011 column, Italy&rsquo;s debt fundamentals are a disaster. Today, Italian spreads over 10 years German <span class=\"scayt-misspell\">Bunds<\/span> exceed 4.5% &#8211; escalating to levels of 15 years ago. Back then, the debt\/GDP ratio was as high as today&rsquo;s, but the primary balance was in a much better shape. With spreads at these levels, the haircut requirements for banks borrowing against Italian collateral will further reduce the attractiveness of Italian Bonds and accelerate the roll-over crisis.<\/p>\n<p>\n\tUntil a few months ago, the markets gave too little consideration to Italian fundamentals, assuming that Italy&rsquo;s default and <span class=\"scayt-misspell\">EZ<\/span> exit was impossible. Today&rsquo;s spreads with today&rsquo;s deficits make a dangerous combination. Mr <span class=\"scayt-misspell\">Berlusconi&rsquo;s<\/span> resignation, while probably necessary at this point, will hardly be a sufficient substitute for a painful and prolonged fiscal adjustment.<\/p>\n<p>\n\tMr. <span class=\"scayt-misspell\">Berlusconi<\/span> has lost contact with reality&nbsp;&#8211; according to him, Italians are unaware of the crisis, as &ldquo;restaurants and travel agencies are full&rdquo;. The truth is that the country&rsquo;s shambles are well epitomized by the recent floods in Genoa and in the beautiful <span class=\"scayt-misspell\">Cinque<\/span> Terre of <span class=\"scayt-misspell\">Liguria<\/span>. Decades of abuse in construction, lack of infrastructure investment and widespread corruption are finally taking a heavy toll &#8211; on the land as well as on the economy.<\/p>\n<p>\n\t<strong>Original column<\/strong><\/p>\n<p>\n\t<strong>31 October 2011<\/strong><\/p>\n<p>\n\tMany observers of the European debt crisis have embraced the idea that the dangers, in particular the risk of default of Italy, lie in the possibility of &lsquo;multiple <span class=\"scayt-misspell\">equilibria&rsquo;<\/span>. According to this view, when economic fundamentals, such as the debt\/GDP ratio and the primary balance, are not quite &lsquo;as good&rsquo; as to guarantee solvency but not quite &lsquo;as bad&rsquo; as to make the country plainly insolvent, then the equilibrium outcome depends on market expectations (see for example <span class=\"scayt-misspell\">Alesina<\/span> et al 1989). In other words, self-fulfilling prophecies may generate opposite and unpredictable outcomes, for the same level of fundamentals. If the market assigns a high probability to a default, it will require a very high risk premium in order to buy governments bonds, making it convenient (or unavoidable) for the government to default, rather than risk strangling the economy in order to generate the surplus required to repay the loan (bad equilibrium). Whereas, if markets are confident in the government&rsquo;s ability and\/or willingness to repay, the low yields will generate the right incentives for the government to <span class=\"scayt-misspell\">fulfil<\/span> the market expectations (good equilibrium). This gives rise to the idea that &lsquo;credibility is everything&rsquo;.<\/p>\n<p>\n\tOne corollary of this approach, at the European level, is that unless the <span class=\"scayt-misspell\">EFSF<\/span> has sufficient firepower to fight off a speculative attack, say &euro;3 trillion, it may not prevent a rollover crisis stemming from a shift in market expectations. Another corollary, relating to the Italian case, is that a sufficient condition for saving Italy is for Mr <span class=\"scayt-misspell\">Berlusconi<\/span>, who has lost international credibility, to step back. I argue here that this latter condition, while possibly being necessary at this stage, is unlikely to prove sufficient. Market fundamentals are, unfortunately, still decisive.<\/p>\n<p>\n\t<strong>The theory<\/strong><\/p>\n<p>\n\tThe argument for multiple <span class=\"scayt-misspell\">equilibria<\/span> has a number of problems. From the standpoint of the theory, it is well known that this result stems from two simplifying assumptions: that each economic agent fully observes all the relevant fundamentals, and that everyone has no uncertainty about the <span class=\"scayt-misspell\">behaviour<\/span> of other agents. This allows agents to coordinate perfectly on one or the other equilibrium. Yet, if these assumptions do not hold, then economic fundamentals are back on <span class=\"scayt-misspell\">centre<\/span> stage, as they unambiguously determine expectations themselves. Hence the equilibrium is again uniquely determined by the strength of fundamentals (Morris and Shin 2000).<\/p>\n<p>\n\t<strong>The evidence<\/strong><\/p>\n<p>\n\t<strong>Figure 1.<\/strong><\/p>\n<p>\n\t<img decoding=\"async\" alt=\"\" src=\"http:\/\/www.fnarena.com\/ckfinder\/userfiles\/images\/voxeu9-11.jpg\" style=\"width: 700px;height: 322px\" \/><\/p>\n<p>\n\t<br \/>\n\tSource: Author&#039;s calculation on <span class=\"scayt-misspell\">Eurostat<\/span> data<\/p>\n<p>\n\tFor the Italian case, the story of multiple <span class=\"scayt-misspell\">equilibria<\/span> is even less convincing. Figure 1 plots the average interest rate on Italian debt (red line), the ratio of the interest bill to GDP (blue line), the primary balance\/GDP ratio (line in purple), and the debt\/GDP ratio (green line, right scale) from 1996 to 2011 (the euro was introduced in 1999). The Figure shows how, 15 years ago, the elimination of currency risk allowed Italy to bring down the average cost of debt from 10% to below 4% today, while the interest bill fell from 12% to 4% of GDP, allowing a significant improvement of the budget and a strong reduction of the debt ratio, at least until 2004. Note, however that the adjustment effort, represented by the primary balance relative to GDP, gradually weakened over the years. In 2005&ndash;06, coinciding with the third <span class=\"scayt-misspell\">Berlusconi<\/span> government, the debt\/GDP ratio started to climb back (<span class=\"scayt-misspell\">Manasse<\/span> 2011). In 2008&ndash;11, thanks to the crisis and the fourth <span class=\"scayt-misspell\">Berlusconi<\/span> term, the debt reached its 1996 GDP ratio, the primary balance fell in negative territory (and marginally rebounded). Fifteen years of progress were squandered. What the Figure clearly shows is that the puzzle is not that the interest rates are now going up, with a limited impact so far on the interest bill. The puzzle is that interest rates have risen so little and so late, despite the worsening of fundamentals. It is really not necessary to resort to esoteric explanations such as contagion (see <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/6722\"><span class=\"scayt-misspell\">Manasse<\/span> and <span class=\"scayt-misspell\">Triglia<\/span> 2011<\/a>) and multiple <span class=\"scayt-misspell\">equilibria<\/span> in order to explain the recent rise in Italian yields, when the debt\/GDP ratio is back to its 1996 level and the primary surplus is about four points of GDP lower than in 1996.<\/p>\n<p>\n\t<strong>Conclusion<\/strong><\/p>\n<p>\n\tUntil a few months ago, the markets apparently gave too little consideration to fundamentals such as the debt\/ GDP ratio and the primary surplus, thinking that Italy&rsquo;s default and exit from the euro was inconceivable. If markets now think back, we can expect bond yields a return to the levels of 15 years ago. Mr <span class=\"scayt-misspell\">Berlusconi&rsquo;s<\/span> resignation, while probably necessary at this point, will hardly be sufficient and substitute for a painful and prolonged fiscal adjustment.<\/p>\n<p>\n\t<strong>References<\/strong><\/p>\n<p>\n\t<span class=\"scayt-misspell\">Alesina<\/span>, A, A <span class=\"scayt-misspell\">Prati<\/span>, and G <span class=\"scayt-misspell\">Tabellini<\/span> (1989), &quot;Public Confidence and Debt Management: A Model And A Case Study of Italy&quot;, <span class=\"scayt-misspell\">CEPR<\/span> Discussion Papers 351.<br \/>\n\t<span class=\"scayt-misspell\">Manasse<\/span>, Paolo (2011), <span class=\"scayt-misspell\">&ldquo;<a href=\"http:\/\/paolomanasse.blogspot.com\/2011\/10\/berlusconi-nel-chart-of-day.html\">Berlusconi<\/a><\/span><a href=\"http:\/\/paolomanasse.blogspot.com\/2011\/10\/berlusconi-nel-chart-of-day.html\"> <span class=\"scayt-misspell\">nel<\/span> &quot;Chart of the Day<\/a>&quot;&rdquo;, Back-Of-The-Envelope Economics, October.<br \/>\n\t<span class=\"scayt-misspell\">Manasse<\/span>, Paolo and <span class=\"scayt-misspell\">Giulio<\/span> <span class=\"scayt-misspell\">Trigilia<\/span> (2011), &ldquo;<a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/6722\">The fear of contagion in Europe<\/a>&rdquo;, <span class=\"scayt-misspell\">VoxEU.org<\/span>, 6 July.<br \/>\n\tMorris, Stephen, Hyun Song Shin (2000), &quot;Rethinking Multiple <span class=\"scayt-misspell\">Equilibria<\/span> in Macroeconomic Modeling&rdquo;, <span class=\"scayt-misspell\">NBER<\/span> Macroeconomics Annual, 15:139-161.&nbsp;<\/p>\n<p>\n\t<strong>Technical limitations<\/strong><\/p>\n<p>\n\t<strong><span style=\"font-style: italic\">If you are reading this story through a third party distribution channel and you cannot see charts included<\/span>, <em>we <span><span class=\"scayt-misspell\">apologise<\/span><\/span>, but technical limitations are to blame.<\/em><\/strong><\/p>\n<p>\n\t<em>Find out why <span class=\"scayt-misspell\">FNArena<\/span> subscribers like the service so much: &quot;<a href=\"http:\/\/www.fnarena.com\/index4.cfm?type=dsp_newsitem&amp;n=29EB960D-9DFF-C00E-7F6B464E5D52E250\">Your Feedback (Thank You)<\/a>&quot; &#8211; Warning this story contains unashamedly positive feedback on the service provided.<\/em><\/p>\n<p>\n\t<em>Copyright <span class=\"scayt-misspell\">VoxEU.org<\/span> &#8211; the above story was originally published on <span class=\"scayt-misspell\">www.VoxEU.org<\/span> under the title &quot;Credibility Is Not Everything&quot; &#8211; readers reading this story through a third party channel may find that any graphs are not included (our apologies for this technical anomaly) &#8211; here&#039;s a link to the original story on the <span class=\"scayt-misspell\">VoxEU<\/span> website: click <a href=\"http:\/\/www.voxeu.org\/index.php?q=node\/7187\">HERE<\/a><\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Paolo Manasse, professor of macroeconomics and international economic policy at the University of Bologna, argues Berlusconi&#8217;s departure is necessary but not sufficient to address Italy&#8217;s debt issues.<\/p>\n","protected":false},"author":9,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5],"tags":[21,41],"acf":[],"_links":{"self":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59123"}],"collection":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/users\/9"}],"replies":[{"embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/comments?post=59123"}],"version-history":[{"count":0,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/posts\/59123\/revisions"}],"wp:attachment":[{"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/media?parent=59123"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/categories?post=59123"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/staging.fnarena.com\/index.php\/wp-json\/wp\/v2\/tags?post=59123"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}