May 08, 2019
How to think about Italy's fiscal position in 2020
We have found that clarity of vision about the state of the eurozone economy is inversely related to over-reliance on economic forecasts and confidence indicators. It is for this reason that we don't usually report on either and, if we do like today, then it's mostly to question other information and our own expectations.
When assessing Italy's budget deficit going forward, yesterday's forecast of 3,5% by the European Commission for 2020 is a relatively uncontroversial baseline case premised on historical information. But it does not tell us what we need to know. In particular, it does not capture the two conflicting dynamic elements that could push us far away from the baseline: a positive growth shock and further fiscal relaxation.
As we have been arguing before, the fiscal multipliers in Italy are probably much larger than generally assumed, especially coming after a long period of fiscal consolidation. This would suggest that fiscal expansion could have an unusually strong growth effect. We cannot be certain that this is so, but it would be consistent with the recorded 0.2% qoq increase in Italian GDP during the first quarter. This was probably one of the biggest recent data surprises, and that information was not yet available when the Commission computed its forecast. In the absence of a global economic shock, it is conceivable that the growth rates both for the eurozone and for Italy could exceed expectations by quite some margin. The Commission forecasts Italian GDP growing at 0.1% for the entire year - already exceeded in Q1 - and 0.7% in 2020.
The biggest uncertainty of all remains Italian politics after this month's European elections. The forecast does not take into account yet-to-be-agreed income tax cuts as demanded by the Lega. If the Lega's election results are as good as expected, its relative power inside the government would strengthen. In this case we would expect no efforts towards a Maastricht-compliant Italian EU budget for 2020, resulting in a renewed excessive deficit procedure. There are several political scenarios. One of them is an election in September. In this case the country is unlikely to have a government and a 2020 budget in place for the looming EU fiscal deadlines in the autumn. It is also possible, but not certain, that a centre-right majority government or a Lega minority government would be fiscally more conservative than the current coalition.
The European Commission's current forecast makes the assumption that the automatic increase in VAT is not going to happen.
We also note the Commission's estimate of a rise in the debt-to-GDP level from a projected 133.7% this year to 135.2% in 2020. What the forecast confirms, and what we knew before, is that the combination of weak economic growth and the country's fiscal position is not sustainable.