The Economist and the 2007 Budget

The Economist has an article this week on the latest budget proposals, and they are not exactly amused by what Tommaso Padoa-Schioppa has been up to (thanks Roberto for the link).

Basically the Economist are crying foul (the article is sub-titled Another year. Another Italian budget. Another ruse). The object of their ire is a provision in the proposal to transfer half the money collected by employers on behalf of their workers (for things like severance pay, and wages in the event of bankruptcy) and not handed to pension funds to the government for safe keeping.

The draft 2007 budget unveiled by Mr Prodi's finance minister, Tommaso Padoa-Schioppa, includes a provision to transfer half the cash not handed to pension funds to the government. This may be defensible, since it trims a hidden subsidy to Italian business (in the form of cheap financing). What is inexcusable is that the budget treats the cash as revenue, not as a debt that will have to be repaid. The forecast inflow, €5.3 billion ($6.7 billion), makes up over a third of the amount that the government claims to be cutting from the deficit.

In particular the Economist is angry with Padoa-Schioppa:

This is not the sort of thing you expect of a former board member of the European Central Bank. But it shows how far Mr Padoa-Schioppa has had to bend to placate demands by left-wing parties within the government.

Well quite. But the issue is rather more important than the personal credibility of one ex Central Bank Director. As the Economist points out the sum involved is around one third of what the government claims to be cutting. So this is not small beer. So the issue really is just how serious is the Italian government in getting to grips with the structural deficit problem. I have reproduced the graph from the Economist article at the start of this post (a graph which, as Claus Vistesen comments, says it all).

The Italian government has a long term structural deficit and this will not be resolved by one-off measures like the one mentioned above, even were these licit ones. As it is the proposal is far from licit, in the sense that the money transferred constitutes a future liability. Naturally I imagine Padoa-Schioppa can use the 'pyramid-sales' type argument that this debt will never be repaid as one generation of workers replaces another, but recourse to this kind of argument would seems to reveal just how much they are missing the whole point of the situation, since in the future each new generation will not replace the previous one.

The Economist speculates on whether or not the EU Commission will buy the proposal, but I would frankly be much more concerned about the rating agencies who may well downgrade Italian debt if the deficit is not within the agreed limits next year, and on the reaction over at the ECB to any ongoing downgrade process.

And even aside from the 'ruse' issue, there are reasons to worry about whether the budget will deliver all that it claims it will deliver. In the first place there is the little question of the 7 billion euros of extra revenue which are anticipated from curbing tax evasion.

There are in fact reasons to doubt the viability of this number precisely because of the other (third) leg of the budget: the tax increase from an overall 41% to an overall 43% rate for those earning €75,000 a year or more. Now obviously an increase like this is likely to increase rather than reduce the temptation for evasion (you know, you go to the dentist and they ask you, would you like the work with or without a bill).

The change in the tax structure is really based on the old Keynesian idea of Marginal Propensity to Consume (that is the idea that the poor spend a higher proportion of their income than the rich) and this thought seems to lie behind Hans's recent commment that "redesigned tax rates will put more money in the pockets of the little woman", and this may be, but let us not forget there is another version of the MPC issue and it is *age related*: people in the 50 to 65 age group have a greater tendancy to save a higher proportion of their income (or spend a lower portion) than those in the 35 to 50 age group, and in each and every one of the years to come Italy will have more people in the former group and less in the latter one, so there is an inbuilt structural tendancy to reduce consumption each year as we move forward. This is what an ageing population means.

Also, and finally, all the budget calculations are based on a growth estimate for next year which may turn out to be considerably over-optimistic in the context of the way the global and eurozone economy is currently moving. So my advice is to watch all this very carefully as 2007 progresses. Someone, somewhere is in for a stormy ride.

September Retail Sales

Retail sales were up in September, and this, as Paola would point out to me, is thoroughly consistent with the September confidence index reading:

Italian retail sales rose for the first time in eight months in September on promotions and increased consumer spending, a Bloomberg purchasing managers index shows.

An index of retail sales rose to a seasonally adjusted 51.2 from 48.7 in August, according to a survey of 390 retailing executives compiled for Bloomberg LP by NTC Economics Ltd. today. It's the first time since January that there's been a reading above 50, which signals an increase.

``Italy's economy is growing at its fastest pace in five years, and consumer spending is the engine,'' said Francesca Panelli, an economist at Aletti Gestielle Sgr in Milan. ``It's clear that going forward that growth is going to slow.''

So September was a good month. This is fine, but it is worth digging a little bit under the surface to try and see what is actually happening.

In the first place we should note that this is the first time in 8 months that this has happened, and during this time the European economy has been having something of a growth renaissance, so that in itself is rather troubling.

Secondly part of the reason for the September flurry has apparently been a reduced price stock-clearing operation, and this 'mini boom' may therefore not find too much of an echo when it comes to profitability:

The increase in sales ``was generally linked to increased marketing and promotional work,'' NTC said in the report. ``There was also some mention of higher customer attendance.' taly's summer sales season wrapped up in September, with retailers slashing prices and clearing out old inventory. As a result, profit margins continued to decrease, according to 23 percent of those surveyed. Profit margins tightened the least since May as promotions boosted sales, the report said.

And looking to the future interest rates are rising, and fiscal tightening is just round the corner:

The European Central Bank raise interest rates by a quarter of a percentage point today, a move that may also slow spending toward the end of the year.

``Higher rates definitely will increase spending on mortgages and loans and will reduce consumer spending,'' Panelli said.

So bearing all these factors in mind I think there is still every reason to ask whether all in the garden is as rosy as it seemed in September, after all you can't keep winning the world cup every couple of months.

Macroeconomic Implications of Demographic Developments in the Euro Area

The ECB has an interesting and useful Occasional Paper on the above topic (which can serve as a good point of departure for those who are unfamiliar with the issues raised).

The paper contains a useful summary of the 'best guess' arguments about potential demographic trends. As they indicate the three parameters involved - fertility, longevity and migration - are all subject to variance and volatility, so any longer term projections must have a fair degree of uncertainty attached. However it is clear that Europe is getting older, and has (and will continue to have) below replacement fertility. These features will undoubtedly condition the macro economic climate for many years to come.

Abstract

This paper examines the macroeconomic consequences of future demographic trends for economic growth, financial markets and public finances. It shows that in the absence of reforms and responses by economic agents, the currently projected demographic trends imply a decline in average real GDP growth and a severe burden in terms of pay-as-you-go pension and health care systems. Population ageing will change the financial landscape, with a potentially larger role for financial intermediaries and asset prices. All this points to a need to closely monitor demographic change also from a monetary policy perspective. While population projections are surrounded by considerable uncertainty and the effects of demographic change tend to be drawn out, the magnitude of the potential effects calls for an early recognition of this issue. This paper provides some input to the examination of possible policy issues.

More On The 2007 Budget

Following-up on what I was saying at the weekend about the details of the 2007 Italian budget proposals, Padoa-Schioppa is adamant that the proposals conform with the requirements of the Stability and Growth Pact. Prodi is too:

"We'll meet the European parameters in 2007, not 2008, and we're committed to putting public accounts in line also in the future"

Not everyone, however, is completely convinced:

``The markets will have to analyze the budget carefully,'' said Salvatore Zecchini, professor of economic policy at Tor Vergata University in Rome. ``The spending cuts are one big question mark, and we'll have to see if the fight against tax evasion will generate the forecasted income.''

``Prodi wasn't strong enough to get the budget he wanted,'' said Gianfranco Pasquino, a professor of political science at Johns Hopkins University's School of Advanced International Studies in Bologna, Italy.

``The message of this budget is that the Italian government has been unable to force or convince unions that pension reform is necessary.''

Prodi's effort to raise the retirement age in Italy was excluded from the budget last week, when he gave into demands from union leaders and its communist allies. Three billion euros in pension spending reductions are included in the budget.


In addition the budget itself is not lacking in opponents, whether from the right or from the left, and the government's wafer thin majority in the senate raises the issue of whether or not it will be watered down before finally being adopted. Certainly something to watch.