What game is Mario Monti playing?

Last month, I talked about the route that Mario Monti should take with Italy if he truly wanted to get it back to a higher-growth path. My advice was to take on the rent-seekers in blitz-reforms, whilst keeping the population in a state of great anxiety about the economy in order to reduce political opposition. Freeing the Italian economy from the many rent-seeking groups that stifle it was in my opinion needed to get long-term growth. I questioned whether Mario, the ultimate financial insider, was up to that kind of job.

How did he do?

Well, I would say he went one-third on the mapped route. As advised, he moved with lightning speed, bringing forward a set of reform packages by December 4th, less than a month after taking power. Also, as advised, he went for some quick hits on existing vested interests. His increased tax on property and his taxing of funds owned up to after a tax-amnesty make up the majority of his tax increases and are visible forms of taxing the wealthy. He went for welfare reductions by removing the indexation of pensions for a few years (exempting the poorest) and a general tax increase via more GST.

In terms of long-term reforms, he went for pension age reform, which is a move that will not have major short-run fiscal benefits because in reality almost no-one works until the official pension age anyway and hence pension age reform should be seen as a long-term reform designed mainly for the civil service that retires early: it takes a long while for the various pension ages to adjust to the official one and for significant groups of people to go through the new system. Perhaps most important for the long term is that Monti is trying to reform the calculation of pensions such that they reflect total contributions rather than the wages of the last few years. Anyone who knows anything about pensions knows that that is a fairly revolutionary change and that it cant be done in the short run. It simply cannot be implemented retrospectively because of missing information about past wages. It is even hard to imagine that the whole stock of current employees close to retirement will be subject to this change, so I can only guess that the fine-print will say that it only applies to pensions from some far future date. It is a good example though of the kind of reform that economists have been calling for for decades (it is a key example in my own co-written econ textbook) but that you need the right moment for in order to push it through politically.

Yet, Mario didnt go for the truly debilitating special interest groups that would open up the economy in the short-run. No tackling of the laws on retrenchment, which is a real problem for hiring. No tackling of the professions (doctors, etc.), which debilitate much of the tertiary sector. He is even promising more unhelpful subsidies for business, like subsidies for eco-friendly building.

Hence, to be brutal, Mario went for the easier targets and didnt do much. Reduced welfare, an indexation freeze on pensions, indirect increases in income tax (i.e. via the states and not the central government), increases in GST, and a couple of obvious long-run reforms that will take decades to come into effect. No concerted effort to go after the tax avoiders and the fat-cats that dominate the political landscape in Italy. No major clashes with the unions either. Indeed, the size of the reform (20 billion Euro more taxation and 10 billion extra spending) is pretty paltry if you consider the problems that Italy faces (with about 2 trillion in debt). There is hence more of the appearance of decisive action, whilst the reality is that of a couple of helpful long-run changes whilst no major interest group has been offended in the short run. Indeed, all the reforms look pretty much off-the-shelf to me, which tells you there is little going on in the background in terms of policy development. Italy is not getting ready for real change.

What does this mean for Italy in the longer run? It most importantly means that there is now a much higher chance that Italy will default on its government debt: the reforms are simply not enough to either pay back the debt nor do they give confidence in medium-term future economic growth that would get rid of the debt.

Mario Monti undoubtedly knows this. So what game is he playing? Is he hoping for a miracle in the form of suddenly returning faith that Italy will always pay its debt and thus a return to 2% bond interest rates? I suspect he is not really hoping for a miracle but consciously has resigned himself to some form of default and meanwhile simply refuses to attempt the politically difficult, which is to take on the major interest groups that paralyse Italy and make it a place you prefer to visit rather than work in.

It is hard to know what Monti’s end game is, or even if he has one. Perhaps he thinks he can have another round of more serious reforms if this one gets through parliament. Perhaps he simply thinks this is the best he can do given the internal political realities of Italy. Perhaps he is trying to put Italy in the position where it could get by if it merely defaulted on the foreign part of the debt, not the domestic part, which in turn would strengthen its bargaining position in a bailout scenario. Whatever the end-game is, with these baby-reforms Monti has proven himself to be a conservative who will not upset the internal status quo. They chose well.

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5 Responses to What game is Mario Monti playing?

  1. john says:

    Japans mafia made the job of ‘liquidating’ the domestic debts left over by their real estate bubble a dangerous job ; literally bottom of the harbor for at least one banker .

    Could Italy (and even Monti personally) have a similar problem re Italy’s ‘domestic debt?

  2. conrad says:

    “nor do they give confidence in medium-term future economic growth that would get rid of the debt.”

    With a population that is already fairly old, 1.39 births per female, and no huge populations of well educated Italian speakers not in Italy that might like to migrate there, it’s hard to imagine how they are going to pay this debt back even with many of your reforms (excluding large dollops of inflation which I somehow doubt older voting Italians would likely to be in favour of, even if they could do that to the Euro).

  3. Paul Frijters says:

    john,

    unlikely. Italy is still a rough country at that level, but if Mario were afraid of such things he wouldnt have taken on the job in the first place.

    Conrad,

    I dont really agree with that. Yes, the very long term looks bleak given no kids, but no kids in the medium run also means no transfers and education expenses for a generation. If they can keep the Italians working longer and return to 2% real growth per year then paying back the loans is easy. Most people pay back more than 120% of their annual income on mortgages they have during their lifetime and the interest rates on those mortgages is much higher. When you reflect on it 120% of GDP in loans is not much of a mountain for a growing economy: its already only worth half that after 30 years of 2% merely due to growth.

  4. JC says:

    Yes, the very long term looks bleak given no kids, but no kids in the medium run also means no transfers and education expenses for a generation.

    Yes, it’s true that some of the demographic stuff is a little too pessimistic seeing we lead longer lives and could be productive beyond 62 or so. However oldster are conservative and don’t like taking risk. How does that play out in achieving a decent level of economic growth?

    Most people pay back more than 120% of their annual income on mortgages they have during their lifetime and the interest rates on those mortgages is much higher.

    That’s true, but far more income goes towards paying interest than it does for a sovereign. Look at what’s happened. Although Italy can withstand a little while with higher interest rates seeing their duration is around 7 years. They can’t role the book over at that rate and not expect serious consequences. Prior to the crisis they were rolling debt at around 3.5%. That roughly means an interest cost of around E 60 billion. The rate has gone to 6.7% 2 which means the assumed interest cost blows out to E 114 billion. Obviously that means they have to find E54 billion from somewhere. That’s 4% of the budget in an economy where they are running a deficit of 4% and no growth and needs to be closed.

    Furthermore there are large licks of debt that have to be rolled. What happens if they can’t find a buyer? Unlike a mortgage holder s/he doesn’t have to roll the debt over in a spooked market, so on that score it’s not the same.

  5. Bill Posters says:

    I suspect he is not really hoping for a miracle but consciously has resigned himself to some form of default and meanwhile simply refuses to attempt the politically difficult, which is to take on the major interest groups that paralyse Italy and make it a place you prefer to visit rather than work in.

    And why wouldn’t you? Default is the way out, everyone is just pretending to avoid it by this stage. Sure it will make borrowing more difficult in the short term but it’s not like people are lining up for Italian debt now anyway.

    In the meantime, austerity is bad for what’s left of the economy so lip service is all any rational leader would give it. A better use of effort would be shoring up the tax base, which is notoriously weak in Italy (and Greece).

    There are plenty of Australian tax professionals who would be willing to club together to buy a ticket to send Michael D’Ascenzo over to help. As long as it was a one-way ticket.

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