Why is Italy’s debt so high?
Is it because the Italian government was fiscally irresponsible, spending too much and taxing too litte? Or is it because investors demand such high interest rates on Italian government bonds? Or is it a consequence of Italy’s dismal economic performance in recent years?
To answer this question, we can take a simple decomposition of the debt-to-GDP ratio. First, remember the government budget constraint:
where B is public debt, G is spending, T is revenue and r is the interest rate. Second, take the time derivative of the debt-to-GDP ratio
Combine the two equations and denote the GDP growth rate dY/Y by g:
This equation allows us to decompose the total change in the debt-to-GDP ratio into a primary deficit component, an interest component and a growth component. The graph below shows this composition for Italy during the pre-crisis period (2000-2008) and the post-crisis period (2009-now).
In the years between the introduction of the euro and the financial crisis, Italy’s debt ratio decreased slightly by about 2 percent of GDP. During the years after the crisis, it increased by almost 30 percent of GDP.
What changed? As you can see by looking at the yellow and blue areas in the graph, it wasn’t interest payments or the primary surplus. Interest payments were around 5 percent of GDP both before and after the crisis and the Italian actually ran a primary surplus in both periods. What changed was the green area: the recent rise in the debt ratio is almost entirely due to Italy’s shrinking economy.
Mario Draghi’s responses to questions at the press conference held in Frankfurt on June 6th are for the most part nothing short of terrifying. I could probably make several posts covering the different levels of shortcomings, but will at the moment only discuss one and link to another very obvious and disheartening one which has been dealt with already by Krugman and Sumner. Yet what struck me as well is that apparently Draghi is making the same mistake that Joan Robinson, otherwise certainly an excellent economist, made all the way back in 1938 by claiming that the hyperinflation in the Weimar Republic could not possibly have been caused by loose monetary policy because interest rates were “high” during the time. At least since Friedman pointed it out clearly in 1968 (.pdf) I thought everyone should be aware of the problems involved in trying to draw conclusions regarding the stance of monetary policy by simply looking at current rates. Draghi states that
“I think that all in all we are currently taking a much more conservative stance, although our monetary policy remains accommodative and, as I said, it will stay accommodative for as long as needed.”
of which the first part is unfortunately true yet a mistake on a policy level, and the second one is plain and simply wrong. Which leads me to the article by Friedman, in which he mentions that
“As an empirical matter, low interest rates are a sign that monetary policy has been tight […]; high interest rates are a sign that monetary policy has been easy.”
Again, low interest rates are a result of a depressed economy, and a depressed economy is more often than not (and I would argue both Japan’s lost decades as well as the current situation in the US and the Eurozone proves this) a result of inadequate monetary policy to begin with. The current level of interest rates is generally a dismal indicator when trying to assess the current stance of monetary policy. So equating low interest rates with easy money is missing the point conceptually, but even if it were not, by any measure that matters, interest rates at the moment are not “accommodative” in a sense that they are helping boost the economy either. The current level of interest rates set by the ECB is the prime reason the economy is being held back, not that it is recovering! A more accurate description of current ECB policy would be something along the lines of
“I think that all in all we are currently taking a much more conservative stance, which is deeply regrettable but whatever. Our monetary policy remains deeply contractionary and, as I said, it will stay contractionary because…SQUIRREL!”