Sunday, March 23, 2014

Italy: Good News, But Still Way Too Much Debt

by Pater Tenebrarum

Matteo Renzi Proposes Sweeping Tax Cuts

Italy's new prime minister Matteo Renzi is reversing some of the worst aspects of the legacy of the Brussels-approved professional bureaucrat Mario Monti by proposing a package of tax cuts, which is mainly going to be financed by spending cuts. This is of course what should have been done from the very beginning. Better late than never though. However, there is one slight flaw that is rightly criticized by some observers:

“Italian Prime Minister Matteo Renzi on Wednesday presented a sweeping package of tax cuts, saying they could help economic recovery in the euro zone's third largest economy without breaking EU budget deficit limits.

Renzi, in his first full news conference since taking office last month, said income tax would be reduced by a total of 10 billion euros ($14 billion) annually for 10 million low and middle income workers from May 1.

"This is one of the biggest fiscal reforms we can imagine," he told reporters after a cabinet meeting that approved the measures.

The cuts will be financed by reductions in central government spending, extra borrowing and by resources freed up thanks to the recent fall in Italy's borrowing costs, he said.

Daniel Gros, the head of the Brussels-based think tank CEPS, said it was worrying that Renzi appeared to be back-tracking on previous pledges to finance any tax cuts entirely with structural spending reductions.

"This is not what Italy needs," he said. "We don't know what bond yields will do in the future and, with its huge public debt, the government cannot afford more deficit spending."

Economy Minister Pier Carlo Padoan said the government would have to evaluate the effect of its measures on public finances and would need to seek EU approval if deficit and debt targets appeared in doubt. Renzi, the 39-year-old former mayor of Florence, said his agenda to stimulate the economy and reform Italy's political system was the most ambitious Italy had ever seen as he reeled off tax-cutting plans that he insisted were fully funded.”

(emphasis added)

We agree with Mr. Gros that the tax cuts should ideally be fully funded by offsetting cuts in spending. Of course, cutting government spending doesn't merely offset the revenue effect of tax cuts at a 1:1 ratio. Such calculations are too simplistic. Given that the economy is likely to perform better following the tax cuts, revenue is likely to increase to a greater degree than it would have otherwise. A major reason to plead for more spending cuts is rather that government spending burdens the economy.

To see why this is so, one need only keep in mind that government produces nothing of value. Every single government function could in fact be privatized and would thereafter be both cheaper and more efficient – including functions that are traditionally held to require government ownership. Let us however leave these finer points aside for now and look at it from the traditional viewpoint (namely the viewpoint that some services should remain in the hand of a territorial force monopolist).

That still leaves a gargantuan amount of spending that could be cut. Government spending is consumptive, and often directs funds to politically favored special interests. However, capital and other factors of production are scarce, so the question is really: should bureaucrats commandeer them, or should the private sector be given the opportunity to make use of them? The answer to this question should be clear. In short, it would undoubtedly be even better if Renzi were indeed matching his tax cuts euro for euro by spending cuts. Still, his plan is a great deal better than leaving Monti's austerity legacy untouched.

Complacency Not Warranted

While it is heartening that Renzi has decided to rather cut taxes than to embark on more government spending in light of Italy's lower funding costs, Daniel Gros is also quite correct in pointing out that is not possible to tell what these funding costs will be in the future. In addition, it is quite clear that Italy's public debtberg remains way too high in toto.

Regarding the yield on Italian government debt, things are almost going too well at the moment. Consider e.g. the 2-year bond yield depicted below:

2-yr.yield, ItalyItaly's 2 year note yield is at the lowest level in quite some time. From the late 2011 panic high, it has by now declined by a huge 650 basis points – click to enlarge.

10 year bonds meanwhile are yielding about 3.4%, which is also a multi-year low. In short, the markets are currently in quite a forgiving mood, especially considering the next data series. Italy's debt-to-GDP ratio has increased by over 13 percentage points since the crisis peak:

italy-government-debt-to-gdpItaly's public debt-to-GDP ratio has continued to rise at a worrisome clip since the height of the sovereign debt crisis – click to enlarge.

Obviously, any unexpected increase in funding costs would be a lot more painful today than it was a few years ago. Bringing this debtberg down should therefore remain a major priority. This is obviously another very good reason to cut spending further.

Italy's stock market has performed quite well of late. Investors have decided to more or less ignore the geopolitical news that have briefly upset markets elsewhere, instead preferring to focus on the improvement in Italy's domestic economy, tentative though it may be so far.

MIBThe MIB index is at a new high for the move – click to enlarge.

To put this rally into perspective, the index remains more than 50% below its all time high of 2007. It also remains below the post-crash rebound highs that were attained in the initial rally from the 2009 panic low. The chart continues to be reminiscent of the moves in the post 1989 crash Nikkei and one should probably not get carried away just yet. As the long term weekly chart shows, the MIB is currently approaching a major long term resistance zone:

MIB, weeklyThe MIB, weekly – closing in on a major resistance level – click to enlarge.


Renzi's decision to cut taxes is certainly a refreshing change from what has heretofore happened in Italy in terms of economic policy. However, he is probably much too timid regarding spending cuts in light of the precarious public debt situation. Many are convinced that the euro area crisis is entirely vanquished, but we are far less certain of this. It seems rather that it has temporarily been transmogrified into 'suspicion asleep'. This happy state of affairs is unlikely to last, and Italy's debtberg is so large that the country remains a potential flashpoint.

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