This is Italy’s Debt clock. And here a version that showcases Italy’s gigantic, ever-increasing debt to anyone who arrives in Rome via train. This clock is sending a clear message, Italy’s debt is a big problem. A message that is constantly repeated by politicians and journalists from frugal North European countries like the Netherlands, Denmark, Sweden and Germany.
So, imagine my surprise when I came across this report by the Dutch Institute for Public Economy that argued that Italy’s debt, is NOT the problem. Their main piece of evidence for that statement is that Italy’s debt has actually grown by about as much as that of other European countries, thanks to government spending cuts. So, they argue that the only reason that people talk about Italy’s debt, is that its economic growth has been terrible over the last decade, making it much more difficult for Italy’s government to actually service its debt!
After all, if you listen to economist talk about government debt, it is almost always expressed in terms of GDP, using this ratio, the debt to GDP ratio.
The reason for this is that both government income and expenses are for a large part determined by GDP, which represents the total income of people in the economy. After all, people pay a percentage of their income to the government in the form of taxes. So, if the economy gets bigger, so does tax income for the government. On the flipside, social security payments, which are a big chunk of government spending, are highly reliant on GDP. You see, if an economy is doing poorly, it’s government will need to spend a lot more on social security, while, at the same time, the income it gets from taxes will go down.
So, because GDP determines both government income and expenses, it is THE factor that determines whether or not government debt is high or low, not the amount in Euro’s. And, that is why this debt clock with Euro numbers ticking up, is meaningless. What really matters is the Debt-To-GDP ratio.
But, in fairness to Italy’s critics, with its debt to GDP ratio at roughly 150% many economists and investors do actually consider it too high. So, with that context in mind, when the Dutch Institute for Public Economics says that
1 Italy’s Debt is not the problem
they mean that this debt part of the debt to GDP ratio is not the problem.
Their main piece of evidence to support this view is that, in absolute terms, Italy’s debt level hasn’t actually grown that much. For example, if we compare Italy’s government debt growth to that of Belgium, which had a similar debt to GDP ratio in 2002, we can clearly see that debt in Euro terms has grown roughly at the same rate in both countries. Even more strikingly, debt has grown at a similar rate in fiscally prudent Germany as well.
Italy’s modest debt growth can be explained by the fact that, under pressure from North European countries, Italy massively reduced its public spending after the Euro crisis of 2011. It’s so-called austerity program included cutting investment in public services such as schools as well raising the retirement age to 67, which is even above even the Netherlands. And all of this was done while raising taxes. I mean, in 2015, the OECD even rated Italy’s austerity efforts as significantly stronger than those of Germany. So, it makes sense that public debt didn’t grow so fast.
However, if we look at the Debt to GDP ratio for the same countries, we can clearly see that Italy’s Debt to GDP ratio has increased by much more than that of Belgium and Germany.
So, then, if debt itself cannot explain Italy’s sky-high debt to GDP ratio. Then, the only logical conclusion would be that Italy’s economy hasn’t grown enough. And, if we look at the data, we can indeed see that while the Belgian and German economies kept growing nicely, Italy’s economy stagnated.
So indeed, the evidence supports the view that Italy’s debt is NOT the problem. Its real problem is that its economy has not grown enough, which makes the debt more difficult to service. But that raises the question,
2 Why Italy has a growth problem
One controversial explanation that economic researchers have found is that Italian GDP likely declined by an additional 5% due to austerity measures. In other words, by cutting government debt, Italy potentially increased government debt to GDP!
Now, I understand that for some of you this might seem like an impossible finding. After all, for people like you and me the most straightforward way to reduce our debt is to cut your spending, right?
Well, yes. For example, I get in trouble to repay my mortgage debt, then spending less on frivolous stuff like gaming computers, fashionable outfits, and expensive coffee is an economically wise decision. Of course, in the meantime, I should continue to work, as the income will make it easier for me to make my monthly mortgage payments.
This strategy works for me because my reduced spending does not reduce my income. Sure, my reduced spending hurts the economy and my income, from sponsor integrations like the one you just saw, depends on how well the economy is doing. However, because I run a small business, my reduced spending doesn’t hurt the economy by enough to reduce my income.
This is where governments are different. Governments are so big that cutting spending unwisely can reduce both their current and future income. And just to get a sense of how big it is, Italy’s government spending typically contributed a whopping 50% to GDP. Its sheer size means that, unlike for a household, reducing government spending reduces both debt and GDP. And since government income and expenses depend on how well the economy is doing, it could be that by cutting spending, by for example firing teachers or hospital staff, governments also reduce the tax income that they get from these people. On top of that the government now needs to pay them social security benefits. But, it gets worse thanks to what is known as the government spending multiplier. You see, despite receiving some social security, these former government employees now have less spending power and thus will spend less on, for example, groceries, which in turn reduce the income of farmers and shop owners. These will now in turn also spend less, pay less taxes, and some will need social security. In other words, government spending cuts are multiplied in the economy. So, by cutting government spending Italy’s government is hurting GDP by more than the initial cut in spending.
But, it gets even worse, spending on the education sector is typically seen as an investment in the future of the economy. So, by cutting back on investments, the Italian government likely decreased future GDP, increasing future social security spending, and decreasing future tax income.
Now, at this point, I just want to make clear that saying that austerity damaging the economy by so much that it eventually increased debt to GDP ratio in Italy’s case is NOT the same as a saying that austerity is always counterproductive.
But, for Italy, many economists indeed argue that austerity measures likely made Italy’s debt to GDP ratio worse because it reduced the size of the economy. That being said, austerity is probably not the only reason that Italy has a growth problem. After all, austerity measures were forced on Italy precisely because its economy was already doing poorly.
And, indeed if we look at this chart, we can see that Italy’s productivity per hour, while initially high, already started slowing down around the 2000s, when it joined the Euro. So, naturally, many economists argue that Italy should never have joined the Euro because from then on it could no longer devalue it’s currency to keep its competitiveness, leaving austerity as the only option.
Another popular explanation for Italy’s slow productivity growth, that it is dominated by small family-owned companies that have not been able to keep up with a rapidly changing and digitizing world.
But, as noted by German economist Max Krahé, while these explanations can partially explain Italy’s poor economic performance, there is probably not just ONE simple explanation for Italy’s growth problem, it is a combination of these factors.
And so, it makes sense that there are a lot of proposals floating about
How Italy should Grow its economy.
For example, in his study, that I have linked in the description of this video, German economist Max Krahé suggest that the Italian government needs to increase the administration efficiency. What’s more, he suggests that implementing industrial policy in Italy’s lagging south can contribute to an overall growing economy Finally, he suggests that, even though this might temporarily increase debt to GDP, investments in education, healthcare, railroads and & digital infrastructure are needed to reduce Italy’s Debt to GDP in the future.
And this where the report by the Dutch Institute for Public Economy, that I have also linked in the description of this video, argues that the EU can help. After all, because Italian borrowing costs are really how right now, the EU could play a big role in precisely these kind of pro-growth investments.
But, what do you think, should Italy’s government reform more, possibly with the help of the EU? Or is the country a lost cause? And, more importantly, do you agree that Italy’s debt problem is indeed actually a growth problem? Let me know in the comment section, or consider joining my Patreon to support my independent analyses and gain access to an exclusive discord server where we can discuss this in more depth.