Good debt, bad debt

Speaking in Rimini back in August 2020, Mario Draghi called for a distinction between “good” debt, being used for productive purposes, such as investing in infrastructure, research and human capital, and “bad” debt, being used for unproductive purposes. Draghi further warned that low interest rates are no guarantee of debt sustainability; the key rather is that investment and reform drive sustainable economic growth. Newly appointed as Prime Minister, Mario Draghi now faces the challenge of putting his advice into practice. The extent of his success will matter not just for Italy, but for Europe.

With Italian bond yields in check, thanks not least to the European Central Bank’s promise of maintaining the Pandemic Emergency Purchase Programme until “at least” March 2022, the European budget rules suspended until 2022, Italian banks entering the crisis well capitalised and around €80bn (5% of GDP) of EU grants to spend, Mario Draghi enjoys a stronger hand than many of his technocrat predecessors, that often came to power with a mandate to apply austerity.

The present day task in Italy is nonetheless momentous; in the recovery after the euro area debt crisis, from 2014 to 2019, economic growth averaged just 0.8%; compared to an average of 1.5% from the arrival of the euro in 1999 until 2007, the final year before the Great Financial Crisis. Moreover, looking at GDP per capita, Italy entered the Covid19 crisis at 7% below the level that prevailed in 2007, pointedly illustrating that the economy never fully recovered from the previous crises. General government debt, meanwhile, has jumped from just over 100% of GDP in 2007 to over 150% today.

The challenge to any programme of structural reform is not only the time it takes to deliver, but the inevitable political roadblocks encountered. The next election in Italy is due by 1 June 2023 at the latest, leaving Prime Minister Draghi potentially just over two years to advance his programme. Hope is that the fact that he has funds to spend, will make growth outcomes visible and ensure his government retains political support. Here too there is a challenge as infra-structure programmes often come with years long lead times. The new Italian government must thus look for the low hanging fruit of “good” debt measures and of reforms with least resistance.

The best opportunity to build a positive impact on economic growth short-term is likely through the confidence channel. Already we see this at work on financial markets with bond yields heading south as equity markets head north. The next step now is to ensure that this confidence feeds through to corporate hiring and investment, and to household spending. Bringing the pandemic under control is a prerequisite, and here the situation remains acute and comes with significant uncertainty.

In the European framework, building confidence offers the additional opportunity to advance Europe’s still incomplete architecture. The immediate priority is to reform the fiscal rules of the European Stability and Growth Pact, that if left unchanged present a real danger of premature austerity with the serious risk of political rejection by national electorates, and not just in Italy. A simple public expenditure rule holds many advantages over the current complex myriad. Ensuring that such rules can be credibly implemented in practice would be further aided by making Europe’s temporary Support to mitigate Unemployment Risks in an Emergency (SURE) and Next Generation EU permanent features. This could also set Europe on a path towards a genuine safe asset, much needed to develop the international role of the euro and Capital Markets Union.

Having delivered “whatever it takes” during the euro area debt crisis, hopes that Mario Draghi will deliver for Italy and Europe are high. It’s worth recalling that during his time as ECB President, he repeatedly called on governments to use the window of opportunity secured by ECB to deliver sound fiscal policies, reform and complete Europe’s architecture. Back then, governments missed, and the temptation of “bad” debt prevailed.

Michala Marcussen,  Chief Economist and Head of Economic and Sector Research for Societe Generale group