Prodi’s bid to balance books earns credit where credit is due

Date: 19/02/1998

ITALY'S public debt problem is often talked about as though it were as natural a phenomenon as death or taxes.

In fact, it is a relatively new aspect of Italian life whose origins lie in the immediate post-war years and the 'pay later' extravagance of the Sixties.

It is only possible to appreciate the important strides made by the past five Italian governments in bringing down inflation and broadening the state's revenue base by comparing them with many of their ostrich-like predecessors.

A fundamental problem is the size and role of Italy's public sector.

As Rome University Professor Fiorella Padoa Schioppa Kostoris explains: "It is clear that, on the one hand, the public sector intervenes in Italy too little where there are obvious market failures but, on the other hand, it intervenes too much where there are no compelling reasons to do so."

Before the war, Benito Mussolini formed giant holding companies to guide the investment and pricing activities of the private sector. Post-war, a culture developed of shaky coalitions formed with the express purpose of keeping the Communists out of power. Interest groups had to be bought off continually.

Like other European countries, Italy was also deeply divided along regional lines, with the differences particularly marked between the northern regions of Lombardy and Piedmont, and the Mezzogiorno in the south. Massive fiscal transfers headed south to support industry and wages.

In the Sixties, the Italian authorities made their 'pay-as-you-go' pensions system more generous but, towards the end of the Seventies, a rapidly greying population and the trend for early retirement caused it to accumulate huge deficits.

The public sector was used - as it was in many countries when Keynes was not a dirty word - to absorb jobs lost in the private sector. However, this economic safety-valve was slow to shed workers when necessary.

The upshot was that, by the late Seventies, the government had started to run a wide primary budget deficit. Yet once inflation was taken into account, the 'real' rate of interest paid to creditors was negative. In 1980, long-term interest rates were as much as five percentage points below the inflation rate.

When real rates started to soar in reaction to a severe tightening of monetary conditions by US Federal Reserve Chairman Paul Volcker and in a newly liberalised environment, the costs of servicing the public debt began to snowball and were hit even harder by the fall-out from German reunification.

Public debt, worth only 59% of gross domestic product in 1980, grew to represent 108% of national income by 1992.

Successive governments tinkered with the problem. In early 1992, the administration of Giuliano Amato pushed through a budget-cutting package worth 40 billion ecu. But, in July of that year, a rise in German interest rates designed to choke off reunification-generated inflation was met with a 1.25-percentage-point hike in interest rates by the Bank of Italy to sustain the lira's parity of 748 per deutschemark within the Exchange Rate Mechanism.

Although this was meant to instil confidence in the determination of the authorities to stabilise economic conditions, it had the opposite effect.

The markets knew that a rise in the cost of borrowing might make the lira more attractive to foreign buyers, but would add billions to the government's interest bill.

The lira was sold and then blown out of the ERM on 'Black Wednesday' in September 1992 as corruption investigations consigned an entire political generation to the scrap heap.

From then on, a string of 'technocratic' governments, followed by Silvio Berlusconi's right-wing coalition and Romano Prodi's centre-left team, have tightened fiscal policy by an average of 33 billion ecu per year.

"Hopefully, the next decade will be spent unwinding the Eighties problem," said Riccardo Barbieri, an economist at Morgan Stanley & Co.

Major feature.