Why the Credit Rating Agencies were right to downgrade Italian debt

By: Wolfgang Munchau

Last week, two credit rating agencies downgraded Italy’s sovereign debt to the same level as Botswana’s. The move by Standard & Poor’s and Fitch is more than a reaction to the centre-left government’s first budget after April’s general election. It is a sign of frustration with where Italy’s coalition is headed. After a short period during which the country appeared to recognise the urgency of its economic plight, we are now back to politics as usual in Rome. S&P lowered Italy’s long-term credit rating from AA- to A+, complaining that Romano Prodi, prime minister, is as inclined to muddle through as his predecessor was. Unfortunately, they are right.

Mr Prodi and Tommaso Padoa-Schioppa, finance minister, appear to have prioritised two goals in the difficult budget negotiations: to survive politically and to push the headline number of Italy’s deficit below 3 per cent of gross domestic product. There is a reasonable chance they will meet both targets. The coalition is shaky, but not about to collapse and the deficit is projected to fall from 4 per cent of GDP this year to 2.8 per cent in 2007. The bad news is how this has been accomplished.

There are three inter-related problems with the budget. The first is that an excessive part of the adjustment comes in the form of tax increases instead of expenditure cuts. Second, the government appears to have used accounting tricks to achieve the headline reduction. A third, overarching, criticism is that the budget does not include reforms necessary to generate downward pressures on the deficit in the future.

Tito Boeri and Pietro Garibaldi, two academics from Bocconi and Turin universities, respectively, found that the budget adjustment was heavily biased in favour of tax increases at the expense of expenditure cuts. Writing recently on lavoce.info, a popular website for political and economic comment in Italy, they put the proportion of total adjustment accounted for by tax increases at between 64 and 84 per cent, much higher than the government previously acknowledged.

The reason why the proportion of taxes is subject to such a wide range of estimates lies in the nature of the measures themselves. Some of the burden will have to be shared by regional and local governments, which may decide to raise their own taxes to meet the shortfall.

A large part of the consolidation effort – 0.4 per cent of GDP – is accounted for by an unbelievably impudent accountancy measure. Italian workers are obliged to spend a proportion of their salary on a redundancy insurance scheme. The budget plan has provisions to ensure that some of this money is channelled to the INPS, the national social security agency, from 2007. The budget treats this cash flow as income for the purpose of deficit reduction.

S&P treats it as a loan since it comes attached with future obligations. Of all the macro accountancy tricks I have encountered in the past few years, this is one of the more creative ones. Professors Boeri and Garibaldi concluded their analysis by saying: “We hope that Brussels will reject this operation as a creative accountancy practice, as happened in the past.” I am less certain that this will happen.

Moritz Kraemer, primary credit analyst at S&P, made the interesting observation that Italy does not consolidate by more than the absolute minimum required under the stability and growth pact. When it emerged that this year’s tax revenues were better than expected, the government immediately compensated this by reducing the total deficit reduction effort by an equivalent amount. Since Italy is on course to meet the Maastricht criteria in a formal sense, there is less urgency for reform.

It is unfortunate that we have fallen into a habit in the eurozone of discussing deficits purely in terms of whether or not they undershoot the 3 per cent deficit-to-GDP threshold set by the Maastricht treaty. The legalistic 3 per cent debate fails to take account of the economic issue of the quality of public finances. It makes a big difference whether you spend public money to award above-inflation pay increases to civil servants, as is the case in Italy, or whether you invest it in higher education, as is the case, for example, in Finland. Italy’s primary economic problem is not an excessive deficit as such, but the combination of a deficit and insufficient economic growth. The rating agencies were not just looking for a spectacular headline cut in the deficit ratio. They were looking for reforms that might affect Italy’s ability to reduce the deficit in the long run. Such reforms should first and foremost aim to raise productivity. Second, they should reduce the proportion of public expenditure in GDP. This budget has failed on both counts. Permanent failure would imply that Italy will eventually default on its debt.

The story contains two ironic twists. Yes, it is possible for a country to experience instability in the long run even if it meets the prescriptions of the stability and growth pact in a formal sense. The second irony relates to Mr Padoa-Schioppa, who used to be a member of the executive board of the European Central Bank. The ECB rarely misses an opportunity to criticise politicians for failing to reform and to consolidate national budgets. But when you put one of them in charge of a real-world budget process, subject to difficult political constraints, you find that they behave in a way not dissimilar to the politicians they ritually criticise.

Copyright The Financial Times Limited 2006

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