Evan Soltas
Feb 21, 2012

The Italian Job Well Done

Krugman made a bad call on Italy in its time of crisis

Above we have graphs of the interest rate on the Italian government bonds of ten and five year maturities, respectively. As we can see, investors have consistently judged the Italian government less likely to default in this time frame, and thus the risk premium has fallen, since December 2011.

This date is relevant for two reasons. First, it marks roughly one month in office for Mario Monti, Italy's economist prime minister, who was swept in on a mandate to introduce a moderated austerity package to appease debt markets and to make longer-term structural reforms to the economy, particularly in labor markets. (See this CNBC interview to get a sense of what Monti's promising.)

Second, it marks the time when Paul Krugman wrote in his blog why Monti would fail:

I guess in Europe today “technocratic” is a synonym for “delusional”.

Look, more austerity isn’t going to convince the bond markets that Italy is just fine, let alone cut interest rates sufficiently to make contractionary policies expansionary. In fact, austerity — at least if not accompanied by major policy changes in Frankfurt — is probably self-defeating, because it will hurt the Italian economy more than it helps the short-term budget picture.

Italy faces an immediate crisis of self-fulfilling panic, and a huge medium-term adjustment problem as it tries to get costs and prices back in line with core Europe. The only plausible way to resolve these problems is via much more liberal policy from the ECB, in the form of bond purchases now and an implicit (but understood) willingness to let inflation run a bit high for an extended period.

The story optimists were telling themselves was that all this austerity stuff was to provide cover for the ECB to do the necessary. But this now looks like wishful thinking; Europe’s delusional technocrats apparently still believe that one more turn of the austerity screw will do the trick.

Whoops, I suppose, for Krugman. Now, nobody is saying that we live in the best of all possible worlds here--the IMF expects Italian GDP to contract by 2.2 percent this year and 0.6 percent in 2013, which isn't good but certainly isn't disastrous--but I don't think the empirical evidence supports Krugman's contention anymore, i.e. that all fiscal austerity is self-defeating, and that the only thing we can do is tell the ECB to ease monetary conditions.

Instead, what we've seen succeed has been a policy-mix approach. (1) Mario Draghi's ECB has indeed eased monetary conditions, although perhaps not enough to be optimal, (2) Monti in Italy has passed short-term austerity measured which are well-designed such that they try to reduce the budget deficit while minimizing the effect on GDP, (3) Monti has also passed broad structural reform which should put Italy on a much healthier trajectory.

Confidence is actually important. Bond markets are calming. All because of some careful fiscal austerity and relatively ample monetary easing. The Italian short-term budget picture looks materially improved (see Monti's interview) as do longer-run growth prospects. Ben fatto, signor Monti.