Super Mario: Mission Impossible?

Why is it that politics, which alone has the power to translate analyses into laws, does not adopt Cavour’s phrase “…reforms carried out in time strengthen authority instead of weakening it”?

Mario Draghi

The alternation of political and technocratic governments has been a well-established tradition in Italian republican history since 1953. In a country characterised by a structurally high political volatility, technocratic Prime Ministers typically serve to push through policies deemed necessary yet too unpopular for politicians to implement, knowing that the next election might be just around the corner. One prominent example of this mechanism at work is Mario Monti’s fully technocratic cabinet appointed in 2011, in the midst of the Eurozone crisis when Italy was on the brink of losing market access.

Given Italy’s long history with technocratic governments, it probably does not surprise that Mario Draghi was called in as Prime Minister to guide the country through one of the hardest periods in its post-war history. Will he succeed? And what is at stake for Italy and Europe, should he fail?

A narrow mandate, with broad implications

On the economic front, Draghi begins his term as PM with one objective above all: securing the country’s share of the Next Generation EU package, particularly the EUR 65 bn in grants from the Recovery and Resilience Facility (RRF) of which Italy is the single largest recipient in absolute terms. This relatively narrow mandate has in fact very broad economic implications, as access to the funds requires alignment with the Commission’s Country-Specific Recommendations and hence the National Recovery and Resilience Plan (NRRP) entails a commitment by recipient countries to implement some degree of structural reforms.

This reform element of the NRRP expands Draghi’s narrow mandate into a much more comprehensive task of overhauling the country’s long-know structural weaknesses in the attempt to lift growth potential. During his lifetime Draghi has conjugated experience in academia, the private sector, and bureaucracy. Before becoming “Super Mario”, he was governor of the Italian Central Bank and General Director of the Treasury, positions in which he already showed fine diplomatic skills and played a significant role in the management of the most important Italian SOEs. What is Draghi’s vision for Italy, based on his academic and policy track record?

An MIT graduate, in his doctoral dissertation – written under the supervision of Nobel laureate Franco Modigliani – Draghi focused on the topical issues he will face serving as Italy’s Prime Minister: the relationship between productivity and GDP, and the trade-off between short term objectives and long-term growth. Between 1995 and 2018, the annual growth of labour productivity in Italy was 0.4%, compared to 0.7% for the productivity of capital, and to 0% for Total Factor Productivity (TFP). In 2018, the growth of both labour productivity and TFP was negative – an especially bad performance across the Eurozone. A book could be written on the reasons for this productivity doldrums. But broadly speaking, the literature points towards the micro-firm bias of the country’s productive structure coupled with a dysfunctional labour market, an education system that is inefficient at producing the skills needed in the productive process, and an institutional setting that is generally unsuccessful at retaining human capital and conducive to an unfriendly business environment.

Good Debt, Bad Debt?

The elephant in the room is and will continue to be Italy’s outsised level of public debt-to-GDP, expected to climb close to 160% post-COVID. While any talk of austerity would be misplaced at the current juncture, the question of how to deal with the Italian debt load will need to be considered – especially as Europe will discuss whether and how the rules of the EU fiscal framework (currently suspended) will need to be reformed after the pandemic shock. Draghi has been arguing since the beginning of the pandemic that high levels of public debt are here to stay, but he has also carefully drawn a distinction between ‘good’ (productive) debt and ‘bad’ (unproductive) debt. So far, Italy has accumulated too much debt of the second type. The crucial task of the Draghi government will be to ensure that the debt incurred in the framework of Next Generation EU is of the first type.

During the Nineties, the country faced a crisis of confidence when markets started to question the sustainability of its public debt. It managed to overcome it without foreign support thanks to an ambitious fiscal consolidation effort, structural reforms, and a privatisation plan amounting to 10% of GDP. A similar solution restored market confidence in 2011 when the Monti technocratic government was appointed with the task to push through unpalatable spending cuts and a controversial pension reform that would cast a shadow on the Italian political discourse long into 2018. This time is different: Draghi comes into office with the mandate to spend, rather than cut, and he has already clarified that no tax hike will be needed. In fact, he expressed the intention to simplify the tax system and reduce labour income taxation during his inauguration speech. Regarding corporate taxation, the new prime minister has recalled on several occasions how Italian firms do not diversify their sources of funding – which mainly comes from short term bank lending – and have less equity (greatly needed in the current crisis) than foreign competitors. As a possible solution to this problem, in the past, he referred to lowering capital gains taxes, a measure which therefore should not be excluded. His view about financing lower taxes seems to be through fighting tax evasion, which should be facilitated also by the measures introduced by the previous government to promote more widespread use of electronic payments.

Thanks to the funds that will flow from Europe – particularly the grants, which have no direct effect on the recipient countries’ debt levels – and to the ECB’s asset purchases programs, Italian debt is on a sustainable path as long as market confidence persists (something that is facilitated by the presence of Draghi as PM). More importantly, if the investment injection from Next Generation EU proves successful in lifting growth, the current financing conditions are consistent with Italy achieving debt stabilisation without the need to run a primary surplus. While a pace of debt reduction aligned with the prescription of the EU 1/20th debt rule would be unfeasible and unwarranted after the biggest economic shock in post-war history, a slower pace of debt reduction would be feasible without imposing undue austerity. In other words: ‘good debt’, if coupled with reforms to remove the structural bottlenecks that have been holding growth back, could create the conditions for Italy to somewhat effortlessly reduce its debt burden to a level that will be safer not only in terms of the markets’ perception but also in terms of the fiscal room for manoeuvre in case of future shocks.

Creative Destruction?

However, not all measures the new Prime Minister will have to take are going to be popular. On multiple occasions, Draghi has pointed out that governments’ attempts to contain this crisis risk producing a wave of zombie firms. Therefore, we expect this government to carefully scrutinise the widespread support now in place as an emergency response to the pandemic. The rationale, which he expressed in the latest G30 document and remarked in his speech before the Italian Parliament, is aligned with his discourse about debt – i.e. that the government should step in only when market inefficiencies are particularly stark, since “every resource wasted today is a damage to future generations”. Accordingly, there would be no need to provide state financing to large enterprises which can access market funding at low borrowing costs, while SMEs with less bargaining power may need more help, hence partial subsidies are likely to remain in place.

Italian data show that state guarantees have insofar avoided a significant wave of bankruptcies, with insolvencies in the first three quarters of 2020 being 15% lower than the average of previous years. This presents a dilemma to the government, which will need to navigate between the need to avoid a spate of insolvencies and the risk to allow for an excessive zombification. Based on the positions expressed so far, it seems reasonable to expect that this government will move from a framework of broad-based measures to one of targeted interventions, allowing some reallocation of resources to occur. As Draghi himself put it, the government must protect workers, but protecting all economic activities without distinction would be a mistake. Although limited nationalisations are a possibility, support in form of targeted credit and quasi-equity instruments will likely be the main course of action.

Beyond Italy

The appointment of Mario Draghi as Italy’s PM will have important repercussions at the EU level as well. One of the most experienced leaders in the Union’s policy landscape, Draghi is best placed to naturally substitute Merkel in the driving seat of EU integration at a time when the Chancellor is about to step down and French President Macron is facing elections. In the past, Draghi has expressed support for a reform of the EU fiscal framework and defended low-rates in front of German critics. Still, his vision is very clearly rooted in the idea of a trade-off between solidarity and responsibility, which suggests he will leverage European support to stabilise Italy’s financial position, but also restore political capital through a clear assumption of responsibility.

A net contributor to the EU budget, Italy becomes a net beneficiary of a fiscal transfer under Next Generation EU. This creates an enormous responsibility for the country, as failure to stimulate growth would not only signify a waste of EU resources but also likely kill the first step towards a genuine fiscal union. For this reason, at this juncture growth is for Italy not just an economic necessity but also a political imperative. Draghi warned parliament that now is the time to act with courage without wasting time, calling for a rebuilding of the country. He knows probably better than anyone what needs to be done to seize this once in a lifetime opportunity to face the country’s long-lived weaknesses. If he succeeds in his mission, he will also be in a position to shape the future of European integration for years to come.

Silvia Merler – Head of Research, Algebris Policy & Research Forum

Antonio Focella – Junior Research Analyst, Algebris Policy & Research Forum

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