Fiscal policy and price stability: The case of Italy, 1992-98

Chicago Fed Letter, Dec 2006 by Bassetto, Marco

Many authorities at home and abroad questioned Italy's ability to meet the strict criteria to join the European Monetary Union. The author looks at the interaction between fiscal policy and monetary policy in Italy between 1992, when it exited the European Exchange Rate Mechanism, and 1998, when an official announcement was made that it would join the union.

It is widely recognized that all episodes of high inflation across the world were accompanied by rapid money creation on the part of a central bank. At the same time, most of these episodes occurred in countries that faced serious fiscal imbalances.1 The central banks of these countries caved in to the needs of the fiscal authorities, because of either political or institutional constraints.

In this Chicago Fed Letter, I look at the interaction between fiscal policy and monetary policy in a somewhat different case, one in which the central bank consistently experienced a high degree of independence and no fiscal crisis occurred: namely, Italy between September 1992, when it exited the European Exchange Rate Mechanism (ERM), and May 1998, when an official announcement was made that it would join the European Monetary Union (EMU).2 While Italy's central bank was not actually forced to run (and did not run) the printing press to bankroll public deficits, I argue that movements in the exchange rates and, to some extent, inflation were dominated by the people's expectations about what could have happened. These expectations were driven mainly by fiscal news. During the run-up to the European Monetary Union, uncertainty about Italy's ability to join exacerbated the swings in expectations, which made the Italian experience a somewhat extreme but particularly informative case.

Fiscal and monetary conditions in Italy after the ERM crisis

While Italy experienced moderately high rates of inflation throughout the 1970s and the early 1980s (peaking at around 21% in 1980), by 1992 inflation had been stable at around 5% for many years. The Bank of Italy had gradually become more and more independent from the executive branch over the previous decade. This trend toward greater institutional independence started with the widely acclaimed "divorce" in 1981, whereby the bank was no longer forced to act as a residual claimant of unsold Italian Treasury debt securities. Aside from gaining more institutional independence, the Bank of Italy also enjoyed a large degree of popularity and respect from the public-a further benefit of disinflation that reinforced its ability to run an effective monetary policy.

Throughout the disinflation period, independence from the executive branch was accompanied by tighter involvement in the European Exchange Rate Mechanism. Central banks participating in the ERM committed to keep their currencies within a narrow band. While the band was periodically readjusted, participation in the quasi-fixed exchange rate regime limited the freedom of the central bank, and it was an important element for the Bank of Italy in regaining credibility for pursuing price stability in the eyes of the public and the financial markets. The Italian commitment to the ERM was suspended in September 1992, following unprecedented speculative attacks. This suspension was triggered in part by domestic weaknesses and in part by larger international considerations. On the domestic front, the ability to sustain a strong exchange rate was challenged by the same fiscal concerns about the ability to manage debt that would play such an important role in the subsequent years. From a broader perspective, the ERM was particularly fragile in the wake of German reunification: The British pound abandoned the system at the same time as the Italian lira, and the following year the trading bands for most currencies were widened sixfold. Leaving the ERM implied that, for the first time, the Bank of Italy would have the responsibility of conducting a truly independent monetary policy, free from both internal and external constraints.

The disinflation of the 1980s was not matched by equal progress in public finances. On the contrary, higher real interest rates and the ceasing of seigniorage revenues3 led to increasing deficits. Government debt in 1992 stood at over 100% of gross domestic product (GDP) and continued to grow rapidly, with interest payments imposing an ever-increasing burden on the budget. Even the very large fiscal adjustment (almost 6% of GDP) approved after the shocking exit from the ERM only managed to slow the growth rate of debt in relationship to output.

Fiscal uncertainty and monetary policy

The solution to the Italian fiscal imbalance could come from one of three sources (or a combination of them):

* An increase in taxes and/or a decrease in spending,

* A spurt of inflation, and

* Outright repudiation (or a capital levy).4

To gauge the extent of inflation and default risk, one can see that yields on Italian ten-year government bonds in the last quarter of 1992 averaged 13.85%, almost 9% above inflation. Several studies have looked at decomposing this risk into the risk of devaluation/inflation and outright credit default.5 These studies found that the pure credit risk of Italian sovereign debt was small, but not insignificant, suggesting that financial markets viewed reversion to high inflation (or a capital levy across a broad spectrum of financial assets) as a more likely outcome than repudiation. More than simply providing seigniorage revenues, inflation would act as an implicit default on existing government debt, since most of it was denominated in domestic currency and was not indexed to prices. The effectiveness of inflation was somewhat limited by the short average maturity of debt.6