Europe’s Fateful Choices for Recovery – An Italian Perspective

To fight COVID-19, the EU must recognize that spending restraints have to go

The Eurozone and the European Union are now debating several schemes for recovery. These proposals differ profoundly in the weight they place on various institutional vehicles for recovery. Some suggest that Italy and other countries should rely on the European Stability Mechanism. Others emphasize a proposed new Recovery Fund. Evaluating these options is difficult, because of the complexity of the considerations involved.

Normally countries needing assistance shun the European Stability Mechanism, because of the harsh conditions attached to its use. European Union authorities have responded by fashioning a set of rules for a “pandemic” ESM that would be less heavy handed than earlier Eurozone interventions, as, for example, in the case of Greece. But despite the absence of ex-ante conditionality (save in regard to the allocation of funds) even this new form of ESM-lite harbors significant dangers since its use still involves ex-post surveillance by Eurozone authorities of the macroeconomic outlook and budgetary policy of debtor countries. It is also fully embedded in the regulatory framework of the Euro Treaties and thus in those fiscal rules that have already demonstrated their dysfunctionality, especially in times of crisis.

The Recovery Fund proposal advanced by the European Commission has only a very small component, in the case of Italy, of “grants” in the sense of fiscal transfers. But the Fund would have the important advantage, within the current institutional framework, of allowing the country to carry out public investments that promise to help growth in the economy in the coming years, while repaying the funds over a long period of time.

In this commentary, I begin by outlining the macroeconomic framework necessary to understand what is at stake and the likely effects of economic policies; I will then briefly describe what is currently being done in Europe and elsewhere; then turn to the difficulties of the Italian situation, a possible (narrow) path of growth and stabilization, and finally discuss European proposed measures against this background.

1. Changes in “mainstream” macroeconomics, institutional analyses and policies since 2008

The standard version of macroeconomic models taught in textbooks before 2008 predicted that restrictive fiscal policies would have negative effects in the short term, but neutral or positive in the medium to long run as they would favour growth in private investment and/or private consumption. In the 2000s the so-called expansionary austerity thesis spread (mainly promoted by Italian economists with an international profile) predicting that austerity policies could immediately and exclusively have positive effects on GDP growth. This thesis was immediately criticized, in particular by researchers at the IMF, but it was nevertheless widely used in Europe and Italy to support the austerity policies implemented after the crisis.

After 2008, many studies have reviewed the effects of recessions and austerity policies. These studies have generally led to radically different conclusions from previous ones:[1]

1) Restrictive fiscal policies always have negative effects on GDP.

2) The negative effects of restrictive fiscal policies (as well as those of recessions) do not have transitory (short-term) but persistent effects. That is growth resumes, but GDP does not return to its previous trajectory, there is lasting damage.

3) The effects of fiscal policies are stronger in recession or stagnation: i.e., restrictive fiscal policies in an economy already in crisis cause greater damage than if they were carried out in a “healthy” economy.

4) Given the above points, it may happen (and has generally happened after 2008, particularly in European economies subject to austerity) that restrictive fiscal policies cause an increase in the debt-to-GDP ratio.

5) Expansionary fiscal policies, if they have a sufficiently high impact on GDP, may reduce the debt ratio. That is, the debt ratio can be reduced by deficit-spending policies, provided the spending is such as to ensure a significant impact on GDP (a high fiscal multiplier).

These views have slowly percolated even into – to some extent – the European institutions and we find them in the supporting document to the Commission proposal on the so-called Recovery Fund:

  • “The overall package is ‘self-financing’. A large share of the financing supports public investment; this has a multiplier larger than one, meaning one additional euro in public investment leads to more than one euro additional of GDP […] The assumed favourable effects from additional provision of finance to the private sector increase government revenues via automatic stabilisers. […] By 2030, the average debt-to-GDP ratio in the EU is estimated to be almost 3 percentage points lower than in the baseline scenario” (Commission Staff Working Document – Identifying Europe’s recovery needs,27/5/2020; doc 520020SC0098, p. 31).

The same document forecasts for high debt countries a reduction in debt–to-GDP of 5 points by 2024, and 8.5 over a longer period compared to what would be without the spending policies allowed by Next Generation EU program the Commission proposes.

In the light of this now widely shared economic analyses, we must therefore stop thinking that more deficits always mean more debt-to-GDP, and that in order to reduce the latter, budget surpluses must be the rule. The macroeconomic effects are more complex, since GDP is not independent of public budget policies.

What has just been said about the evolution of macroeconomic analyses is mirrored by what is being done in the various countries in response to the crisis. Everywhere we see extremely expansionary fiscal policies, much more than in 2008 and after. According to data provided by the International Monetary Fund (Policy responses to Covid, updated 24/6/2020), in the US there were more than 3,000 billion dollars (about 15% GDP) of direct expenditure and tax cuts; in Japan about 21% of GDP;[2] in Germany, €327 billion between regional and federal levels of government, about 14% of GDP. The fiscal stimulus is much more moderate in Italy, where measures have been approved for 5% of GDP, and in Spain (3.2% of GDP).

It should therefore be noted that the pattern of national fiscal stimuli at the moment in the Eurozone is such as to exacerbate the processes of divergence already underway in the Eurozone.

Monetary policy in all the large countries outside the euro area has accompanied fiscal expansion with a variety of exceptional measures, which have everywhere also involved an unlimited purchase of government bonds together with an explicit commitment to maintain low and stable interest rates on public bonds in the future.

2. The European context and the Italian situation

As far as fiscal policy is concerned, the fiscal rules of the European treaties have been temporarily suspended in Europe. In addition to the ‘pandemic’ ESM and the proposed Next Generation EU (Recovery Fund), to which I will return, the SURE fund of 100 billion has been set up to support the unemployed along with 25 billion guarantees from the European Investment Bank to support credit for businesses - rather little in terms of macroeconomic impact for the EU27.

So far, therefore, the additional public spending needed to face the health emergency and to compensate the incomes lost because of the latter has been provided by national governments and generally funded by issuing public bonds.

For monetary policy, the ECB has launched government bond purchase programmes (extended until June 2021) with temporary flexibility regarding the rules that impose proportionality criteria between countries (the so-called “capital keys”). In fact, the ECB normally has to buy bonds strictly in a proportion reflecting Eurozone countries weight in the European GDP and hence in the ECB capital endowment. Relaxation of this rule, along with the large amount of purchases, have contained interest rate spreads across Eurozone countries.

Note however the uncertainty due to the suspension but not revision of monetary and fiscal rules. The German Constitutional Court ruling, which questioned the legitimacy of the quantitative easing policies undertaken by the ECB before the Covid19 crisis has added to the uncertainty.

In this uncertain context, Italy has to reckon with its high debt-to-GDP ratio, which comes from a long time ago, and which thirty years of primary surpluses have failed to bring down. Italy entered the 1990s with an already high public debt (about 120% of GDP). This was due not to high public spending in comparison with other European countries, but to insufficient tax revenues and high interest rates during the 1980s associated to monetary and exchange rate policies that generated a snow-ball effect and a doubling of the debt-to-GDP ratio. Since 1992 Italy has always had primary surpluses (the only country in the eurozone). This means that fiscal revenues have always exceeded public spending in services, investment and transfers (such as pensions and unemployment benefits), except interest payments. Even disregarding the consequences for the quality of welfare and public infrastructure, such surpluses slowed down GDP and productivity growth because of their negative impact on aggregate demand.[3]

Despite this, low interest rates allowed a reduction of the debt-to-GDP ratio to a 100% in 2008.

However, the fall in GDP in 2008 brought the debt-to-GDP ratio back to 120%. After the crisis, austerity policies undertaken during the ‘interest rate spread crisis’ led to a further fall in GDP in 2012 and 2013 (-4.5% in two years) and a persistent increase in the debt-to-GDP ratio to 135%. In 2019, Italy had not yet recovered the levels of GDP and employment (measured in in hours worked) of 2007.[4]

The current situation is for an expected fall in GDP of around 10% in 2020 and then a recovery by about half of that percentage in 2021. Together with current budget deficits, this would bring Italy’s debt-to-GDP ratio roughly at 160% this year and around 155% next year. Although Italy has some strengths such as high private wealth and a net external debt close to zero, under current European monetary and fiscal rules, the high debt to GDP ratio is a problem. Unfortunately, these rules are difficult to change, although it is now widely recognised that they are dysfunctional and pro-cyclical, i.e. they tend to amplify recessions[5] and as recently stated by Lagarde, need to be changed.

The only possible path for Italy in the present context is one that maintains, for long periods of time, the average nominal interest rate on the entire stock of public debt lower than the nominal GDP growth rate:

r < g

Very simply, if the primary budget is balanced, r is the rate of growth of debt, while g stands for GDP growth.

The ideal solution for Italy (as well as for other European countries) to get out of the high debt would be the transformation into perpetuities, or very long maturity bonds, of the public debt already held by the Bank of Italy (purchased on ECB mandate).

The purchase of perpetuities by Central Banks is currently proposed by many parties, even of high technical and institutional profile, but for now ECB President Lagarde has branded it as a purely intellectual exercise and, unfortunately, the proposal does not seem to be on the agenda. In its absence, it is necessary at least to guarantee the rollover of the debt stock and the closure (or sharp tightening) of the spreads now and in the future through the intervention of the ECB in the secondary markets. That this is necessary is also pointed in a recent article by Fabio Panetta, member of the ECB board,[6]and is basically what central banks outside the Eurozone are doing everywhere. However, the outlook for the eurozone is uncertain on this point too.

Thus, the average interest rate on the debt stock is basically in the hands of the ECB and in its ability to ‘reassure the markets’. For Italy, the intervention of the Central Bank is essential, since the major problem is not how to finance current deficits, but to refinance the stock of debt that each year comes to maturity (an order of magnitude of hundreds of billions a year) at a low interest rate. Of course, measures aimed at bringing the public debt back into Italian hands, and at channelling Italians’ wealth into public investments, as currently attempted by Italian government, are also useful. Their purpose is to help take public debt away from highly speculative financial institutions and markets and keep the interests paid inside the national income-expenditure circuit. But this should take place at low interest rates - from this point of view, it could be interesting to anchor the returns to nominal GDP growth, with a gap.

The other crucial variable is the growth rate of the economy: the advocated ‘reforms’ often demanded by European institutions can be useful (enhancing public administration efficiency, funding research) or harmful (such as labour market deregulation) but even when useful they have no appreciable effect on growth. The latter can only be stimulated by export support policies and public budget policies with a high impact on GDP (i.e., implying high fiscal multipliers - see the Commission’s ‘technical’ document quoted above). Private investment is, of course, very important, but we know from economic analysis that, at an aggregate level, the single most important factor in stimulating it is demand growth.

Despite the variability of estimates of the absolute values of multipliers, there is wide convergence in the economic literature on the hierarchy of multiplier values.[7]

- The fiscal multipliers of tax reductions (in particular on medium and high incomes) and transfers to businesses are much lower than those of other public spending items.

- The highest multipliers are those of public investment, followed by public consumption expenditure (health, education, etc. – that is, the hiring of staff to provide those services).

Italy should therefore focus on public expenditure with a high multiplier: investments and growth of (qualified) employment in the public sector, which is currently extremely undersized compared to what happens in other European countries.

An increase in interest rates, and/or an attempt to reduce the debt-to-GDP ratio through policies geared to producing primary surpluses in the near future would have steeply increase the debt-to-GDP ratio. The result would be a vicious circle that would lead the country to have to choose between Italexit on the one hand or default with a banking crisis plus intervention of the troika on the other.

3. An assessment of the main European measures: ‘pandemic’ ESM and Next Generation EU (‘Recovery fund’) proposal from an Italian perspective.

In the Italian and European public debate both measures are often presented as generous gifts to Italy from European institutions and European partners, with Italy often presented as a major beneficiary of ‘fiscal tranfers’ from other European countries. But this is not true.

3.1 The ‘pandemic’ ESM

It is a loan that in the case of Italy would at most amount to 37 billion Euros for direct and indirect health care costs, with a 10-year maturity and very low interest rate.[8] The amount would, however, add to Italy’s public debt. The only ex-ante conditionality concerns the broad classes of expenditure.

Advantages in terms of savings on interest payment are small if compared with the alternative of financing such expenditure by issuing public debt bonds. At most and under very extreme assumptions the savings might amount to 700 million Euros per year for 10 years. In fact, though, the savings are much more likely to be around 400-500 million Euros per year – less than 1% the interest payed each year by the Italian government, which amounted to around 65 billion Euros in 2019.

An indirect and very unlikely advantage can be attributed to the fact that recourse to the ESM is a necessary, but not sufficient condition for the ECB to embark on an ‘outright monetary transtactions’ (OMT) programme of unlimited purchase of the country’s securities by the ECB. But this seems extremely unlikely without further conditions and would be undertaken only in dire emergency.

Despite declarations that no conditionality is attached to the programme, some pitfalls arise from the fine print in treaties in which the ESM is embedded, explicitly referred to in the official documents that describe the ‘pandemic’ programme.[9] Under these rules, ESM debtor countries are subject to post-programme surveillance. As Carlo Cottarelli and Enzo Moavero[10] explained very well in a recent article on the Italian newspaper “La Repubblica”:

  • “The effects of the inescapable ‘enhanced surveillance’ are nevertheless significant for the State (see Article 3): a closer investigation of its finances, with the obligation to provide at EU level the same information as under the excessive deficit procedure; the ‘regular review missions’ of the Commission, the ECB, ‘where appropriate, with the IMF’ (the same actors, albeit with a different role, as the Troika); then, the EU Council may - a nodal point - recommend to the State ‘corrective measures” or a “macroeconomic adjustment programme”, a weighty “recommendation’, especially when combined with the fear of negative market reaction.” (Carlo Cottarelli and Enzo Moavero, “La Repubblica”, 28 April 2020).

Thus, negative evaluations of the Italian situation that typically cause turmoil in financial markets could have rather high costs.

In addition, the document accompanying the ‘pandemic’ loan that provide the required favourable assessment of EU countries debt sustainability, contain an expected time-profile of public budget balances. This foresees for Italy an overall budget deficit of 2% in 2026,[11] and thus a sizeable primary surplus, higher than those required of Italy in past years, since the deficit is the same as expected for 2019, though interest payments in proportion to GDP will be higher in the next years given the increase in the debt-to-GDP ratio. In other words, a full return to pre-crisis fiscal rules and policies, to which the country is expected to adhere. As explained above, these would indeed have ‘perverse’ effects on the debt-to-GDP ratio, owing to the negative effects on the denominator.

3.2 The Next Generation EU (‘Recovery fund’) proposal

According to the Commission’s proposal, this would be a ‘package’ of €750 billion over 4 years (for all 27 EU countries) that can be disbursed as loans or grants involving a ‘fiscal transfer’ component.

Before we consider the distribution of the fund as it emerges from the Commission documents, let us see how it would be financed.[12]

Funding arrangements

For all E750 billion, the Commission will turn to financial markets and issue bonds with maturities between 2028 and 2058 at low interest rates. The programme will therefore not (initially) burden individual countries’ budgets and the calculation of their public debt (Commission staff working document, p. 2).

Interest rates on these securities would be paid by the Commission from ‘own resources’ (VAT, ‘green’ taxation; taxes on multinationals). Concerning these resources, it is reasonable to assume that the contribution from each country to the Commission’s revenues will be proportional to its share of European GDP (12.8% for Italy in 2019 - here, as in the European documents, reference will be made to last year’s figures).

Repayment of securities at maturity:

  • ‘Own resources’ from the Commission’s taxation;
  • Repayment to be provided by individual countries, in different proportions depending on the instrument used (grants or loans). Individual countries will most likely gather the resources necessary to repay the loans and grants by issuing national public debt bonds. However, the deferment and long maturity of the securities issued by the Commission (i.e. 2028-2058) is very helpful in easing the reimbursement.
  • Loans must be returned in full by the receiving country and may be requested by each country up to a maximum of 4.7% of its GDP
  • Grants’ are distributed among countries (i.e. their maximum availability is determined) according to a set of indicators (in particular, per capita income levels and unemployment); they are reimbursed according to the share of EU GDP represented by the country. For Italy, simulations of the Commission proposal in the technical accompanying document envisage a maximum disbursement of 20.4 % of the funds available as grants and a refund rate of 12,8 %.

Amounts payable

Of the EUR 750 billion planned, the largest amount concerns the measures provided for in the programme called Recovery and Resilience Facility: 560 billion, divided between 310 of ‘grants’ and 250 of loans both to be used for public investment (mainly ‘green’ and digitisation) and reforms.

The remaining 190 out of the 750 foreseen by the ‘Next generation EU’, spread over a variety of already existing European programmes; of these, 140 would also be distributed as ‘grants’ according to the accompanying technical report (the main items being regional funds for cohesion policies for 50 billions; support for business and private investment for 36 billion; natural resources and environment, 30 billions).

The maximum amount Italy could obtain of the 560 billion according to the parameters indicated above is 63 billion out of the 310 available for ‘grants’, divided over 4 years; plus an overall maximum of loans equal to 4.7% of GDP, i.e. about 83 billion euros overall, spread over 4 years.

Of the remaining 140 billion, by the same criteria Italy would receive a further 28 billion in grants. Altogether, the maximum additional expenditure according to the proposal would be for Italy about 174 billion - 43 billion per year if spread over 4 years, equal to 2,3 % of 2019 GDP. If additional, the expenditure is of a size that can have a favourable macroeconomic impact.

Fiscal Transfers to Italy: very small

The net contribution received by Italy (the fiscal transfer) on the basis of the parameters suggested in the proposal is very small; the countries receiving a substantial net contribution are the East European countries and to a lesser extent Spain, much less Italy. The net contribution to Italy would be at most around 8.5 billion per year for 4 years.[13] This compares with Italy’s annual net contribution to the European budget, which in the past has been for several years between 4 and 5 billion Euros annually (5 billion in 2018), and will probably increase, owing to the intended expansion of the budget in the coming years.

This should make it clear that whatever benefits that might accrue to Italy are not linked to a ‘fiscal transfer’ implicit in the Next Generation EU, and that needs emphasizing during the negotiation process.

For the plan to have a macroeconomic effect, it is imperative, as the accompanying report points out, that the planned expenditure is additional and not a substitute for other expenditures, and that it be concentrated on high-impact expenditure items.

Obviously, the content of conditionality is insidious – will it only concern the destination? what will the proposed reforms be? – and so is the surveillance on implementation, with the possibility that subsequent tranches of funding could be denied. This entails risks linked on the one hand to Italian inefficiencies in spending, but on the other hand also to the influence of political motives on evaluations (which may become more or less severe according to the political orientations and alliances of the parties in government), or to the possible ‘vested interests’ of net contributors in limiting the disbursement of funds.

Since the ‘fiscal transfer’ component is very limited in the case of Italy, in my view the government could and should insist, during negotiations, on a number of points, such that:

  • ‘conditions’ and targets are established together with the government and that counterproductive ‘reforms’ with undesirable social consequences (e.g. further flexibilization of the labour market or wages) can be avoided.
  • periodical ‘reviews’ on public investments and agreed reforms by European institutions are conceived as technical support and not as leading to ‘judgments’ possibly followed by ‘sanctions’.
  • the rules should not be designed in such a way that a country’s failure to obtain the maximum amount of the funds available as ‘grants’ would turn it from net beneficiary into net contributor.
  • maturity of the securities issued by the Commission, which is the real element allowing a macroeconomic impact of the measures, is further extended;
  • the indicators used for allocating the funds include the economic damage suffered as a result of the pandemic (e.g., a fall in GDP and fall in employment, including hours of lay-off, in the first part of 2020 – if such data can be rapidly made available).

To sum up, the advantages of the Next Generation EU proposed by the Commission do not lie – at least in the case of Italy - so much in the presence of ‘fiscal transfers’. (i.e. non-refundable resources) as much as in the temporary removal of spending constraints, with the expenditure not affecting the debt accounting (in fact, a kind of temporary ‘golden rule’ on some public expenditure items), along with the long term maturity and low interest rates on the funds obtained. Indeed, the introduction of a ‘golden rule’ - meaning that public investment is taken out of the public budget accounting and that fiscal revenues would have to be balanced with current expenditure only - has been often advocated as a needed reform of European fiscal rules, even in a recent report by the European fiscal board.[14]

Thus, the contribution of the Commission is essentially in making available the instrument of the debt issuance. The advantages lie to a large extent in the possibility of a temporary overcoming of the European fiscal rules, which should in any case be changed because they are highly dysfunctional. This must be clear to Italian and European public opinion and made effective in the negotiations.

At any rate, whatever the size of the ‘Next Generation EU’, the ECB’s intervention will remain crucial, since without it, the rollover of the debt stock at sustainable interest rates cannot be guaranteed.


[1] For a review of the literature referred to and further evidence see D. Girardi, W. Paternesi Meloni; A. Stirati, Reverse Hysteresis? Persistent effects of autonomous demand expansions, Cambridge Journal of Economics, February 2020

[2] Despite 200% in the GDP-public debt ratio, Japan enjoys high private savings and wealthy households, and has no net foreign debt - in these respects it is similar to Italy, but unlike the latter also enjoys very low interest rates on public debt.

[3] In the Italian context, interest payments on public bonds tend to accrue mostly to large firms, banks, wealthy household, foreign financial institutions. Accordingly, they do not contribute to the formation of domestic aggregate demand.

[4] Paternesi Meloni W. e Stirati A., (2018) Macroeconomics and the Italian Vote, INET Blog, August 2018,;

Storm, S. (2019). Lost in deflation: Why Italy’s woes are a warning to the whole Eurozone, INET WP No. 94;; Heimberger P. and N. Krowall (2020)Seven ‘surprising’ facts about the Italian economy, Social Europe, 25th June 2020;…

[5] European Fiscal Board, Assessment of EU fiscal rules with a focus on the six and two-pack legislation, August 2019

[6] “..what is needed now is for countries to use their collective strength to ensure that the European response is commensurate with the size of the shock and that all countries can benefit from low funding costs and zero rollover risk… the goal of fiscal policy must be to push the financing costs of this crisis far — very far — into the future. Debt that is issued at very long maturities becomes more sustainable over time as growth rates outstrip interest rates” F. Panetta, Joint response to coronavirus crisis will benefit all EU countries, 21 April 2020:…

[7] See Gechert, S. (2015). What fiscal policy is most effective? A meta-regression analysis. Oxford Economic Papers, 67(3), 553–580; Deleidi, M., Iafrate, F., & Levrero, E. S. (2020a). Public investment fiscal multipliers: An empirical assessment for European countries. Structural Change and Economic Dynamics, 52, 354-365, among others.

[8] There is some uncertainty about exactly what indirect expenditure means. On the other hand, 37 billion is too much to spend all of it on health care, especially so since the loan, being a once-for-all provision, could not be used for hiring additional staff, whose costs would be a permanent addition to public expenditure.

[9] In the Term sheet: ESM Pandemic Crisis Support, May 2020, for example we find among other things that: “The ESM will implement its Early Warning System to ensure timely repayment of the Pandemic Crisis Support.”

[10] Both authors have a high institutional profile and are strongly in favour of European integration. In earlier governments Enzo Moavero has been the Ministry of Foreign affairs and before that the Ministry of European affairs.

[11] ESM, pandemic crisis support, Annex II - Assessment of public debt sustainability and COVID-related financing needs of euro area Member States, 07 May 2020, table 1, p. 3.

[12] The numbers and parameters used are taken from three documents: Communication from the Commission to the European Parliament, the European Council, the Council, the European economic and social committee and the Committee of the regions, Brussels, 27.5.2020 COM(2020) 442 final; Commission Staff working document - Identifying Europe’s recovery needs. Brussels, 27.5.2020, SWD(2020) 98,final; Proposal for a Regulation of the European Parliament and of the Council establishing a Recovery and Resilience Facility, Brussels, 28.5.2020 COM(2020) 408 final 2020/0104 (COD). The figures I report are partly different from those presented in Table A.1 attached to the second of the above mentioned documents, as the data in the table are in partial contradiction with the contents of the same and other documents. In particular, in table A.1 the ‘loans’ are not considered as to be returned at 100%, contrary to what stated elsewhere and suggested by the distinction between loans and grants. As a result, in our calculations the fiscal transfers to Italy are lower than reported in Table A.1. In any case, as this is a proposal still under negotiation, the figures must be regarded as simply illustrative of the general outlook of the proposal.

[13] Calculated as 20,4% of the total amount of grants (450) minus 12,8% contribution to the same: 91 - 57.6 = 33.4 to be distributed over 4 years

[14] European Fiscal Board, Assessment of EU fiscal rules with a focus on the six and two-pack legislation, August 2019

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