Saving the Euro: Can a technocratic Italian and Greek leadership rescue the single currency?
Last Updated on Monday, 21 November 2011 14:31 Written by Laurence Boone at Bank of America Merrill Lynch Monday, 21 November 2011 14:18
Laurence Boone at Bank of America Merrill Lynch asks whether the newly installed crop of 'technocrats' can replicate their predecessors who successfully readied their respective nations for EMU membership.
The past couple of weeks have seen prominent “technocrats” appointed Prime Minister in Italy and Greece to lead them out of fiscal crisis. In this note we assess how similar technocratic governments performed in the nineties, when they were in vogue in the run-up to EMU.
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In our view, the implementation of difficult reforms in that period was as much aided by technocratic governments as by the consensus desire to join the euro. If we were to draw a comparison with the situation today, the task of the technocrats now looks much harder: instead of a carrot in the form of EMU there is the prospect of years of austerity and slow growth. Moreover, there seems to be less of a consensus on the necessary goals.
Defining a technocratic government
We would describe a technocratic government as one where technical experts are Ministers in their respective fields. Economists and those with specialist knowledge, expertise or skills make up the governing body so on the whole are not elected, though they are approved by their democratically elected parliaments.
Successful technocratic governments in the nineties
Italy’s technocratic governments between 1992 and 1996 in the run-up to EMU were a success. Reforms they pushed through covered fiscal adjustment, pensions and the labour market. Beginning with the 1992 agreement on incomes policy, which eliminated the wage indexation mechanism, successive technocratic administrations drew up rules governing tripartite policy processes in fields like pensions and labour market policies.
There was a huge incentive in the early nineties to proceed with reforms: namely to be among the club of the first countries to join the European Monetary Union. To achieve this, three conditions had to be met: a reduction in inflation (to close to that of the lowest three countries), a deficit of less than 3% of GDP and government bond yields converging towards that of the three best performing countries. Being part of the ERM (exchange rate mechanism) for two years was a pre-requisite. To this effect, after the signing of the Maastricht Treaty, there was a strong consensus on “what had to be done” within Italy’s political elite, as highlighted in a letter written at the time by Mario Monti and Luigi Spaventa (27 February 1992). Yet it became the task of (mostly) technocratic governments to embark on the necessary reforms to meet these requirements.
The first technocratic government was headed by a politician, G. Amato, and sought democratic legitimacy by reviving the tradition of working with social partners. The Amato government laid the foundation for Italy to join EMU in 1998 by delivering a sharp reduction in inflation, a sizeable fiscal adjustment, and a reduction in bond yields.
The fight against inflation
In July 1992, a month after Amato came to power, the wage indexation mechanism that had been in place in Italy since the end of WWII, “the scala mobile” was abolished. The scala mobile was the subject of an interconfederal agreement, signed by all employers and unions and automatically included in all national labour contracts. The major employers associations had long complained that the cost of living index was a prime cause of inflation and of the wage increases through the indexation mechanism. This led to high labour costs, which strangled the firms exposed to international competition. In July, a pact between the government, the unions, and the employers’ confederation abolished the indexation mechanism and imposed a one year wage freeze. As a result, inflation as measured by CPI went down from 6.5% in 1990 to less than 2% in 1998. Wage inflation dropped from 10% in 1991 to 3.4% in 1998.
We would note, however, that the reform process was the result of tri-partite negotiations and did not involve law-makers. Also, the need to reduce inflation to enter the euro was a powerful stimulus.
Reversing the ever-rising debt
Putting in place measures to reduce the deficit and cut debt was more difficult: it took an exchange rate crisis and a series of technocratic governments. In September 1992 the Italian lira, which had been under pressure from financial markets for a while, had to exit the ERM, in spite of rates reaching record high levels (more than 18% for the 3m rate and 14% for the 10-year). It took several governments to resolve the fiscal and exchange rate problems. In late September 1996, when the Italian government finally understood that Germany was inflexible on the criteria to join EMU, a sizeable one-off effort was made: a one-off tax ensured that the budget deficit dropped from 7% in 1996 to 2.7% in 1997. In November 1996, the Italian lira re-entered the ERM, thus qualifying for EMU.
An interesting comparison with today is that the primary budget increased from a small deficit of 0.5% of GDP in 1991 to a surplus of 6.1% of GDP in 1997, and remained close to 5% until 2000. However, that was not enough to prevent the debt from rising from 100% of GDP in 1991 to 132.6% in 1998, after which it slowly started to decline. This is partly because the biggest adjustment effort took place in 1997.
We attribute the past success of technocratic governments essentially to Italy’s strong desire to be a founding member of EMU. Technocratic governments were as unstable (in the sense of short-lived) as political governments. In our view, this points to a relatively high probability of turbulence today, which is unlikely to ease market anxiety. As we have highlighted elsewhere, it suggests that the government will need some ECB support if it is to be successful in bringing rates down.
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