Italy’s Forgotten Era of Debt Reduction

Romano Prodi
Former Italian Prime Minister Romano Prodi

Photo by PHILIPPE LOPEZ/AFP/Getty Images

Tyler Cowen says that one lesson of the Italian budget crisis is the merits of prophylactic debt reduction even at a time when financial markets are willing to lend to the central government at a low rate. “Roubini forecast the Italian crisis in 2006,” he writes “but overall how many people on the left were so wise to be calling for such Italian spending cuts in 2005, when the country had relatively low bond yields?” 

Certainly that seems to make sense. But it’s worth keeping in mind that before the global financial crisis hit, this is exactly what Italy was doing. A combination of a growing economy and responsible budget practices by two-time prime minister Romano Prodi had Italy’s debt:GDP ratio steadily falling.

Now it’s pretty clearly true that all else being equal Italians would probably be even worse off today if this hadn’t happened and would be better off if they’d pursued steeper deficit reduction earlier. But do note that Spain has a much lower debt:GDP ratio than Italy and that’s hardly kept them out of the woods. There was absolutely nothing Italian governments could have done over the past 15 years to get their debt load down as low as Spain’s, and even if they had it’s not clear that it would have done them much good. Meanwhile, the real sins of Italian fiscal policy that saddled them with this high debt load happened pretty far back in the past.

All that said, the basic Keynesian idea on fiscal policy is supposed to be that deficits can and should get really big during recessions, but there should never be a large quantity of outstanding debt since countries are supposed to run offsetting surpluses during periods of expansion. Few countries have managed to govern this way in practice, but the United States before Ronald Reagan more or less fit the bill, as do most of the Nordic countries today.