The ESM debate in Italy

In the last few weeks political discussion in Italy has been focusing on which measures European Union should use to help countries with borrowing difficulties during the coronavirus economic crisis. This is definitely the worst negative shock we have seen in decades, Italian GPD in 2020 is forecasted to fall by more or less 10%. This unprecedented situation requires governments’ huge funds to finance healthcare systems and to pump liquidity into their economies.

Italy’s fiscal difficulties are well-known since they have been massively discussed since 2011’s sovereign debt crisis. Despite European Central Bank’s Quantitative Easing, Italy might find difficulties to borrow the funds it needs directly from the markets at a sustainable interest rate. Italy proposed other Euro Area countries to issue new shared debt (Eurobonds) or to allow countries facing borrowing constraints to use the European Stability Mechanism without conditionalities. Countries reached a “compromise” solution at the last Eurogroup, which declined Italy’s requests and approved only limited shared resources.
Thus, countries will have to find by themselves on the markets a large share of the liquidity they need. Given the different economic interests among European countries, it is very unlikely that further major measures will be approved. So, the ESM will be the only institution able to lend to Italy, in the (not unlikely) scenario of fiscal sustainability issues in the next months. The major worry about this scenario is that the ESM imposes rigorous conditions to allow a country to borrow from it. These conditions are useful to ensure country’s debt sustainability and they consist in a combination restrictive fiscal policies and free-market oriented macroeconomic reforms (usually called structural reforms in public debate).

Basically, we will delegate our economic policy decisions to a group of economists. Structural reforms could be imposed quickly and effectively by an independent foreign institution, while they would not be easily approved following the normal democratic procedures.

Would the ESM work?

First, let’s analyse which advantage Italy would get by using the ESM. The ESM is an international organization outside European institutions to which all euro area countries give funds proportionally to their GDP. The ESM uses this capital to borrow from the market and lend to euro countries which have difficulties to borrow by themselves. Given its structure and its rules, the ESM will always be a safe borrower. Markets will trust it even during the crisis and they will lend to it at low interest rates. Therefore, if Italian bonds interest rate rose, using ESM would allow Italy to borrow cheaply.

Unfortunately, using the ESM funds also creates some problems. Firstly, the ESM mechanism does not ensure any transfer among euro countries, so it will not help Italy to reduce the level of its debt. Italian borrowings from the ESM will increase Italian debt same as normal debt. Furthermore, using ESM funds could also probably worsen Italian debt sustainability by increasing Italian bonds interest rate, for multiple reasons. The ESM debt would be a “senior debt” compared to Italian bonds. This means that ESM is to be paid before any other creditor. Other investors would know that in case of limited resources Italy would be forced to pay back the ESM firstly and they would consequently prize this risk with an increased interest rate. Moreover, in case of debt unsustainability, the possibility of a debt restructuring is explicitly written in the ESM rules. In fact, the main interest of ESM is to ensure that its lending will be repaid. If a country’s debt becomes unsustainable, a restructuring procedure will be opened. Since Italian sustainability is very questionable after coronavirus crisis, entering the ESM will further reduce Italy’s credibility among investors, who will ask higher interest rates due to the restructuring risk.

Moreover, the ESM was created to solve temporarily fiscal crisis mainly caused by speculation (self-fulfilling expectations and multiple equilibria issues) in the bond markets. A country with solid macroeconomics indicators who pays an unreasonably high interest rate can borrow temporarily from the ESM while implementing some restrictive fiscal measure to prove to the markets its debt sustainability. When it regains markets’ trust and its interest rate falls, it returns to normal activities. The ESM is not the proper instrument for the current crisis for two reasons. First, the economic environment following coronavirus crisis is exceptional and completely different from the one in which ESM was created. We are in real economic crisis, with both demand and supply being heavily hit. In this situation, Italian debt, whose sustainability was already questionable before the crisis, will very likely become unsustainable unless economic activity recovers fully and quickly.

As we said previously, ESM does not help a country with weak economic indicators whose debt sustainability is in danger. Instead, it is likely that it will quicken the vicious circle leading to a debt restructuring. Secondly, the conditionalities imposed by ESM imply a restrictive fiscal policy to guarantee the sustainability of the debt and a debt restructuring if sustainability is no longer achievable. Instead, Italian economy needs a huge expansionary policy to balance the coronavirus economic crisis shock. Italy would borrow from the ESM to pump liquidity into the economy and it would be impossible to return this lending in the short-term. Thus, the ESM would soon impose a very strong restrictive fiscal policy or a debt restructuring to ensure not to lose its lending. Both these scenarios would lead to a second economic crisis which will reset the positive effects of the expansionary policy financed with ESM resources.

Economics becomes politics

The previous discussion already rises doubts about the usefulness of the ESM for Italy. However, we have not reached yet the main problem: conditionalities. As we said, they are imposed to guarantee the country’s debt sustainability. This is necessary because ESM is primarily worried about the solvency of its lending. The ESM is useful if markets trust it and they are willing to lend to it at a low interest rate. ESM rules are written to guarantee it will be a safe borrower in any economic condition.

In the current scenario where all countries have been heavily hit by the crisis, it is unlikely that European countries will allow the ESM lending to Italy non-repayable funds, whose cost would have to be shared by all of them. Therefore, conditionalities are needed to ensure that the borrowing country will pay back its debt, especially the one it has with the ESM itself. Thus, these conditionalities are restrictive fiscal policy, but, since revenues of a government (taxes) depend directly on GPD level, the ESM would also impose policies to enhance productivity and GDP growth. These are more job market flexibility, less distortionary taxes (aimed to maximize efficiency with few concerns about equity issues), a reorganization the public sector, including strategic public goods such as healthcare system, pensions and education, to make it more efficient. These are the structural reforms many economists and politicians have claimed for years.

Some argue that using ESM could turn out to be positive because of conditionalities. They would modernize the country and they would boost Italian economy after the crisis. Before dealing with the political issue of imposing these measures without a democratic agreement, we briefly discuss their efficiency. Unfortunately, even if public debate has continued to claim their need, there is no conclusive evidence about how Italian economy would response to “structural reforms”.
Generally, Italian productivity and GPD have not grown for more than 20 years. Some reforms of this kind have been approved in the last years, but there was no evidence of any major effects. Despite them, Italian economy continued to perform poorly. In any case, even if they turned out to cause a sizable improvement of Italian economy, their effects would show up only in the long run. They aim to boost economy through a more efficient reallocation of factors, innovation and a more competitive environment. These channels require adjustment costs in the short run before becoming effective. Thus, they will neither help to recover from the coronavirus crisis nor to make Italian finances sustainable.

Beyond the questionable effectiveness of the structural reforms, a more interesting and problematic question regards to which extend these can be imposed though the ESM and avoiding the democratic procedures. Many economists think that politics is inefficient in taking decisions regarding economics because politicians’ goals are different from long-term society’s welfare maximization and people are not educated enough to evaluate economic reforms. Therefore, politicians will take sub-optimal decisions, pleasing short-terms desires of the people in order to maximize their popularity and their power instead of the society’s welfare. Economists then claim to delegate more and more political economy’s decisions to independent and technical institutions, able to compare rationally different policies and choose optimally “for the sake of the people”. This belief is a threat for the democratic nature of our societies.

Firstly, there is a lot of heterogeneity and disagreement among economic theories, especially for macroeconomic theories. Second, and more important, even if economics had the perfect recipe to boost growth and productivity, the choice to implement it or not would remain deeply political. There is a strong misunderstanding about how much economics can give a clear answer to political issues. Even if we got a macroeconomic theory able to perfectly fit data and get consistent predictions for the effects of future policies, they would still be the result of an optimization problem, the maximization of goods consumed by households. This is the essence of economics. The perfect economic theory (which is very far to be achieved) would show in the most precise and detailed way what we must do in order to produce and consume as much goods as possible. This is the notion of economic welfare. I am not claiming this notion is wrong for economics purposes, instead it is extremely useful because it allows to simplify the world in mathematical terms and use more rigorous methods to construct theories and verify them empirically.
Thanks to this tools economics has become a science. However, it is trivial to point out that this is an extreme simplification of humans’ behaviour. I do not value my life based on how many goods I consume and I hope nobody among this article’s readers will ever do this.

There are many things more important and more valuable in our life that unfortunately cannot enter economic models. Therefore, while economics as a science gives some clear answer about what should be done to maximize its notion of welfare and it is likely that it will give more (and more precise) answers in the future, the decision to implement what economics proposes is and will always be a political decision, no matter how precise economics will become. Economics does not have any absolute truth about how we must shape our society, nothing closed to this can be proved. This is by its essence a political issue. People are free to choose to live in an inefficient, unproductive and uncompetitive society if they want to. This would not be an irrational choice because the choice for efficiency, competitiveness and productivity cannot be proved to be completely rational, or the only rational decision. Economics rationality is a part of humans’ rationality, which is much more than that.

Thus, using the ESM to overstep democratic debate and impose structural reforms which will change the economy, and thus the society, of a country will be a political decision, because it would not be supported by any scientific evidence. A political choice taken by a minority without the agreement of people is, by definition, a dictatorial decision.

An easy reply to my claim could be that if economics aims at maximizing people’s consumption of goods and it works, it is irrational for people not to follow its rules since everyone is better off consuming more than less goods. Unfortunately, things are more complicated than this. Approving policies that aim at increasing economic welfare will hugely affect our societies and our lives in the long run. It will determine which will be our job, what children will learn at school, how much inequality and how many poor people there will be in our societies, where we will live, how many resources we will invest in public goods, such as education and health. Finally, it will also influence our values and what we think is right and wrong. To be clear, I am not claiming that the economic notion of welfare necessarily contrasts with some needs or desires of people.

“Economics’ welfare” could be positively or negatively correlated with people’s overall political preferences about society and life. My claim is that economists cannot find an optimal solution simply because the choices available are not measurable and comparable using the tools of economics. These are political issues. They cannot be solved scientifically because there are too many variables involved that cannot be measured because they are outside the notion of economic rationality. When people choose differently from what economics suggest, it can be that democracy is an inefficient mechanism to take decisions because people are not able to compare correctly different economic policies, but it can also be that people chose like this because they value more something that economics is unable to insert in its optimality problems.

We cannot know so we cannot judge based on an economic criterium if democratic decisions are right or wrong. When people decide something that is irrational for economics, before worrying that people do not understand economics, we should remember that economics for sure does not understand people.