- Weak popular backing for adjustment and reform underscores the need to give growth greater priority;
- So does the high ratio of debt to GDP, which will ratchet up if GDP keeps declining;
- The ECB could usefully signal that growth is important with a policy interest rate cut;
- The Eurogroup could affirm that no further fiscal adjustment is needed and allow privatization to be used to boost public investment;
- But Italy must still move forward with overdue labor market liberalization.
No plan survives contact with the enemy. That axiom originated with military strategist Helmuth von Moltke, whose Prussian armies won the wars that united Germany. It resonates in Europe today in the wake of Italys inconclusive parliamentary elections. The plan now needing attention is one drawn up last year in Frankfurt, with support from Berlin, which has had great success to date: the ECBs promise, via Outright Monetary Transactions (OMT), to do whatever it takes to calm worries that the euro would not endure.
The OMT promised limitless buying of sovereign bonds maturing within three years for countries with policies passing muster. This condition-based commitment reversed most of the worrisome spike in Italian and Spanish sovereign spreads seen through July 2012 as positive effects from the ECBs long-term refinancing operations unwound and worries about euro exit tail risks grew through two rounds of Greek elections.
Moltkes maxim needs reworking, of course: contact with the electorate is the issue now. The OMT has been successful because market participants came to believe that its policy conditions had already been taken up by Mario Montis interim government and would be quickly in Spain, if need be.
More than half of Italian voters, however, opted for parties whose leaders reject further fiscal consolidation. The further structural reforms needed to access the ESM, a prerequisite for OMT eligibility, are backed only by a small minority of legislatorsmainly those from Montis fourth-place coalition. Lacking the votes to enact reforms, Italy would be ineligible for OMT access.
A core explanation for the recent election results, indeed, must be six consecutive quarters of economic contraction that have brought output 8% below its pre-crisis peak, nearly doubling unemployment to 11.2%.
Prospects for an early recovery, which might have been within reach later this year, must surely worsen if a hung parliament impedes enactment of needed legislation, including the 2014 budget. Uncertainty about policies and the timing of fresh elections may prompt businesses and households to retrench further. Support will then only grow for the protest-oriented Five Star Movement, which calls for a rollback of fiscal consolidation and a referendum on euro membership.
Popular backing for adjustment and reform will be difficult to resuscitate if output keeps declining. Market worries will grow, moreover, if falling GDP keeps ratcheting up the ratio of government debt to GDP.
At 127% last year, this was already above the 120% the IMF now argues is the limit of sustainability. Absent corrective measures that would reinforce output contraction, Italys debt/GDP ratio may be on course to rise by 5-6 percentage points a year if real GDP continues falling at last years 2.2% pace.
These numbers underscore why growth must now become Europes priority. Tricky debt dynamics, should output continue to fall, risk leaving Europe and the IMF arguing about the sustainability of Italian debt, which would damage market sentiment.
Lessening the risk of adverse debt dynamics was part of the OMTs genius. Bond yields and interest payments were capped by the potential for ECB bond-buying. Italys primary fiscal surplus would not have to increase as much. Negative effects on GDP could be contained.
If Berlusconis resurgence and Grillos rise now leave Italy ineligible for the OMT, though, Europe faces a troubling conundrum. Hold firm on conditions for official bond-buying needed to contain yields, which would sustain incentives for adjustment and reform.
Or, compromise on conditionality to limit near-term damage to activity and prevent the further erosion of popular support for the reforms needed to boost competitiveness and strengthen growth when it returns.
Untying this Gordian knot may now require key decisions on two fronts. First, the ECB could usefully signal the importance of renewing growth with a policy rate cut, even though monetary transmission problems remain unresolved.
Second, the Eurogroup could affirm that the fiscal adjustment already in place has brought Italy close enough to structural fiscal balance and that this will suffice as long as tax cuts or new spending are offset going forward.
An important amendment to this would be to allow additional public investment, not offset by other measures, equal to realized privatization receipts. This would incentivize action to fulfill the Monti governments plans to realize 1% of GDP a year from sales of utility stakes and real estate. Realized receipts would keep such investment outlays from adding to borrowing and debt.
Assuming an expenditure multiplier equal to one, the additional investment would add 1% to GDP and 0.5% of GDP to tax revenues while reducing the debt/GDP ratio by 1.7-1.8 percentage points a year from what otherwise might have been.
Ways must still be found to prod Italy to move on overdue labor market liberalization. But action to boost near term growth would help Europe to sustain the popular backing necessary to advance the reforms needed for the longer term.
This article was originally published by the Institute of International Finance.