Why Italian fiscal austerity won’t work
Not now, at least. You don’t have to buy into the more extreme forms of Keynesian economics. In the short run, what the country needs is more revenue, relative to expenditure. If you cut the government expenditures, in the short run revenues go down, including tax revenues. Maybe you substitute in some private sector outputs for public sector outputs and furthermore maybe those private sector outputs bring higher utility to the citizenry. But they don’t bring higher revenue, not in the short run.
The financial crisis, now exacerbated by a revenue shortage, destroys the economy before the potential gains from the expenditure-switching have a chance to kick in. Furthermore, if the broader economy is dysfunctional, the gains from expenditure-switching to the private sector may not show up even in the medium run. Growth-enhancing reforms can take many years to pay off, as we see from the histories of New Zealand, Chile, or the ex-communist countries. Yet even the Italian two-year note shows default risk, yielding twice as much or more as the American 30-year bond.
That said, more government spending probably won’t work either, unless you think that spending is extremely effective in targeting unemployed resources, which in Italy I believe it is not. Neither contractionary nor expansionary fiscal policy will succeed.
The only answer, if that is the right word, is a central bank. Right now central banks need to be doing everything they can to avoid a second Great Depression. I talk to many smart people, and I am continually surprised how many of them do not realize the urgency of the current situation.
By the way, some of the worst features of the Italian economy — paying people to do nothing, or to do the wrong thing — can in the abstract be described as “automatic stabilizers.” Automatic stabilizers play an important and largely positive role in macroeconomic response, but if not designed properly they too can bring or hasten downfall. The automatic stabilizers in Italy have thwarted productive incentives and thus lowered the growth rate. And furthermore, dismantling some of those automatic stabilizers eventually needs to be done, but in the short run again could hurt revenue. When a country uses automatic stabilizers for growth-damaging ends, it paints itself into an especially difficult corner. How to move forward?
The economic policies of the Nordic countries look better all the time, and actually you can add the United States to that list, believe it or not.