Florence is a beautiful city and I was lucky enough to spend time there in May 2017, the first time since my 1978 interrailing trip. The occasion was the European University Institute’s State of the Union gathering. The president and prime minister of Italy; Jean-Claude Juncker, Head of the European Commission; and Michel Barnier, the chief negotiator with the UK on Brexit were among the many speakers. The meetings were in two places. A monastery in Fiesole, an hour’s walk uphill from the centre of the city. From there, there is a magnificent view of Brunelleschi’s dome and Giotto’s bell tower. And Palazzo Vecchio, Florence’s town hall. A larger-than-life size copy of Michelangelo’s David stands guard at the entrance on Piazza della Signoria, a square which, much to the dismay of tourists, was closed off for the security surrounding the event.


Creative destruction

Such beautiful surroundings can have quite an effect on economists. Alan Greenspan, former US Federal Reserve chairman, honeymooned in Venice in 1997. It led him to rethink one of the two main planks of his economist’s view of the world: the benefit of creative destruction (the other being a belief in free market capitalism).


The term creative destruction was coined by economist Joseph Schumpeter to describe the way in which the capitalist system continues to develop new inventions and new methods of production, which replace and destroy old methods. “In with the new, out with the old” is the way economies prosper.


There are limits, of course, to the approach. If that principle had been applied to Florence’s city planning, Palazzo Vecchio may well have been pulled down years ago to make way for a McDonald’s, an underground car park and a “Florence visitor experience” centre. Venice, Greenspan realised, “is the antithesis of creative destruction. It exists to conserve and appreciate a past, not create a future. The city caters to a deep human need for stability and permanence as well as beauty and romance. Nothing is more stressful for people than the perennial gale of creative destruction.”[1] Italy is clearly capable of bringing a change in the way economists think.


Debt snowball

Italy’s economy, and its government finances, have fascinated me for years. In particular, Italy’s government debt level has been high, too high as far as many are concerned, for many years. It has repeatedly been on the edge of what economists consider to be unsustainable levels. But catastrophe has been repeatedly avoided.


The concept of a ‘debt snowball’ goes back to the early 1980s. It says that once a government’s debt level rises above 100% of GDP, it risks growing bigger and bigger, just like a snowball rolling downhill.[2] The reason is that at such a high debt level, the burden of paying interest on a country’s outstanding debt will be simply too high. It will not be possible to cover it by raising taxes or saving money by cutting government spending. It will just roll out of control. The situation is akin to someone who uses a credit card with a high interest rate and does not pay off the full amount each month: the outstanding debt accumulates quickly. The higher the interest rate the faster the debt accumulation.


However, unlike Greece where government debt did spiral out of control in the eurozone crisis, leading Greece to default on its debt, Italy has managed, for decades, to avoid such an outcome. How has that been possible?


Budget deficit: 10% becomes 3%

In the mid-1970s, after the first spike in oil prices, many developed world governments ran large budget deficits. Keynesian demand management policies were in vogue at the time. The view was that governments, including Italy’s, could cut taxes or raise government spending, to offset the squeeze on real incomes and consumer spending from the sharp rise in oil prices. In Italy, that approach was enthusiastically embraced. The government’s budget, close to balance ten years earlier, jumped to 10% of GDP in 1975.


In the following years, when other countries[3] started to rein in the fiscal stimulus and seek to correct their large government deficits and debt levels, Italy did not. For twenty years, from 1975 to 1995, the fiscal deficit stayed at the very high level of 10% of GDP.  Higher deficits led to an accumulation of debt and, just as predicted by the snowball analysis, interest payments took up a larger and larger share of government spending: from under 5% (in 1975) to over a fifth (in 1995).


Even so, Italy’s economy was growing strongly in money terms – that is, considering real growth and inflation. So, although the level of government debt was rising when expressed in Italian lira terms, this was broadly matched by the growth in the overall size of the economy. The end result was that between 1975 and 1984, the debt/GDP ratio stayed constant – at 81%. The snowball effect was avoided.


But Italy’s luck, if it can be described as that, ran out. In the next ten years growth and inflation slowed; the interest rate Italy paid on its debt remained high; and government deficits stayed at around 10% of GDP. That meant that its accumulated  outstanding debt level rose steadily, but relentlessly, to 127% of GDP in 1995. The debt snowball effect couldn’t be avoided.


Maastricht criteria

That did not set an auspicious background for Italy’s potential membership of the euro as the move towards launch of the single currency developed pace, especially from 1995 onwards. To meet the requirements for joining the euro, the Maastricht criteria, Italy had to have a budget deficit no larger than 3% of GDP (and a balanced budget over the ‘medium term’); and total debt less than 60% of GDP.


As the deficit had been 10% of GDP almost every year for the last twenty; and the debt level twice the limit, many (myself included) thought that Italy’s chances of meeting the requirements were slim.


Astonishingly, however, Italy had great success in reducing its deficit in the run-up to May 1998, when the final assessment of which countries qualified to join the euro was made. Italy passed the deficit test. Its government deficit was just 2.7% of GDP in 1997; and it was expected to fall further to 2.5% (on the basis of the European Commission’s forecast) in 1998.[4] How did they do that?


There was an element of manipulation of the data. One technique (used in a number of countries, not just Italy) was to enter into a currency or interest rate swap with an investment bank. For example, Italian lira, which would soon be replaced by the euro if everything went according to plan, could be swapped for Japanese yen. Such a swap could be structured in such a way that Italy received payments, regarded as government revenue, allowing it to reduce its deficit.[5]


Another technique was to force government agencies to meet their spending by running down their accumulated cash reserves (which did not count as government spending) rather than spend new money (which would have done).[6]


Even so, it is clear that genuine progress was made in putting Italy’s public finances in better order. Under the government at the time, the Olive Tree coalition of Romani Prodi, an economics professor from the University of Bologna, there had been progress with reform of public sector pensions and privatisation of state assets. Other economic liberalisation measures were also taken. “It all happened because of Europe. Without Europe, Italy is nothing. Everybody knows that”, Prodi said in an interview with Forbes in late 1998.[7]


Over the speed limit

The second fiscal criterion, on the debt level, was more tricky to meet in the run-up to the launch of the euro. Italy’s government debt in 1997 was 122% of GDP, way in excess of the Maastricht Treaty’s 60% ‘limit’. The details of the Stability and Growth Pact, which fleshed out the provisions of the Treaty provided, however, some leeway. If debt was above 60% of GDP, as long as it was approaching 60% at an ‘acceptable’ rate, then the country could be allowed into the euro. Italy’s debt level had fallen slightly, from 125% three years earlier, but was that really enough progress?  The European Commission judged that it was.


I always think of this flexibility as like driving a Ferrari at more than twice the speed limit and being caught by the traffic police. Would the policeman really let you off the speeding ticket if you claimed “I know it’s a 60 limit and I was doing 122 but just a little while back I was doing 125!” And if he was lenient, should he have been?


The 60% debt rule was actually met by just three countries – Finland, France and Luxembourg in 1998 when countries were assessed for euro inclusion. Germany was (just) over the limit and its debt level was rising, not falling. This undoubtedly brought a more accommodating attitude on the part of those assessing whether the conditions for membership were met.


The analogy with exceeding the speed limit can be extended further. The Stability and Growth Pact included a system of fines for a country if, once it became a member of the euro, it exceeded the 3% deficit limit. When the deficit rose above 3% of GDP, a fine of 0.2% of the country’s GDP would be levied. The fine would increase to a maximum of 0.5% of GDP if the deficit exceeded 6% of GDP. The fines were discretionary if the country was in a moderate economic contraction and were not imposed if the country was in a recession.



The proceeds of the fine were to be held in a non-interest-bearing account at the European Commission. If the deficit were brought under control within 2 years, the money would be returned, without interest. If the deficit were not cut, the fine would be shared out amongst the good guys – those with deficits below 3%.


Such fines have never been imposed, for two main reasons. First, the decision on whether to fine a country was decided by qualified majority voting in the European Parliament, a system which gives a greater weight to the larger economies. This means that larger countries can relatively easily block such a fine being imposed. Second, Germany and France, the two large core eurozone economies, both exceeded the 3% and 60% limits in the early 2000s.  Otmar Issing sees 2003 as the crucial year in a change of attitudes: “Germany and France violated the pact in 2003, delivering a fatal blow to the pact from which it has never recovered. Now the European Commission more or less ignores it”, he commented in 2016.[8]


In 2002, the European Commission did start proceedings against Portugal for exceeding the 3% limit. But Romano Prodi, who had by that time become president of the European Commission, declared the Stability Pact “stupid” in October 2002. “I know very well that the stability pact is stupid, like all decisions which are rigid,” he told the French daily Le Monde. “The pact is imperfect. We need a more intelligent tool and more flexibility.”[9]


Debt, meet Goldilocks

This abandonment of the strict version of the fiscal targets did not lead to an immediate blow out of government deficits and debt levels in the newly-formed eurozone. The mid-2000s were a ‘Goldilocks’ period for the world economy in general, with continued economic growth, low inflation and interest rates. In those circumstances, government revenues were relatively strong and some elements of government spending (such as welfare and benefits, which increase at times of higher unemployment) were restrained. However, as the saying goes, “the time to mend the roof is when the sun is shining”. That is what the eurozone failed to do in the run-up to the financial crisis which started in 2007. It meant that there was a lack of ‘fiscal space’ – an ability to spend more or reduce taxes – once the global recession that followed the financial crisis took hold. The crisis countries tried to mend the roof while the rain was pouring.


Italy provides perhaps the clearest example of a country facing such problems. In August 2011, the ECB demanded fiscal tightening measures and sweeping reforms before it was willing to step in and buy Italian government bonds. In a letter to Prime Minister Silvio Berlusconi, outgoing ECB President Jean-Claude Trichet and his successor, Bank of Italy Governor Mario Draghi,[10] urged more aggressive fiscal tightening, mainly through expenditure cuts.


When Mario Draghi took over as ECB President in November 2011, his first statement to the European Parliament emphasised the need for a ‘fiscal compact’ – a fundamental restatement of the fiscal rules that would make them fully credible.[11]


The European Commission had put forward proposals for a ‘six pack’ of fiscal surveillance measures in September 2010. According to Jean Pisani-Ferry[12], German Chancellor Angela Merkel was not convinced that these new measures were tight enough. She wanted to see automatic fines, similar to those in the original Stability and Growth Pact. Her plans were dropped under pressure from French President Sarkozy.



Vade mecum

Not content with just the ‘six-pack’, a proposal for a ‘two-pack’ was also put forward by the European Commission: this compelled member states to provide in early Autumn each year full information on their budget plans so these could be scrutinised by the European Commission. It could then request changes before national budgets were adopted by national parliaments. The two-pack came into force on 30 May 2013.[13]


This plethora of fiscal rules and requirements has evolved into a situation which is now very complex. In order to help understand them, the European Commission publishes a vade mecum – a “handy pocket guide” – on the Stability and Growth Pact. It runs to 212 pages and is, to be fair, described as “a technical handbook for experts”. But I for one find much of it very hard to get to grips with. If you want to bend the fiscal rules you’ll be sure to find a way of doing so if you look carefully enough. Many others are just as critical. The IMF recently wrote that “rules to contain lavish government deficits are most effective if countries design them to be simple, flexible, and enforceable in the face of changing economic circumstances….rules put in the place over the last three decades often were too complex, overly rigid, and difficult to enforce.”[14] I could not agree more.



Stabilising the unsustainable, again and again


In the eurozone crisis, Italy’s debt level rose from around 100% to over 130% of GDP, but then stabilised at the new higher level. Much of the credit for that stabilisation should go to Pier Carlo Padoan, the genial Italian finance minister from 2014-2018. He speaks perfect English with an Irish twist and was Italy’s director of the IMF in the early 2000s. As such, he is completely familiar with their analysis of debt sustainability. He knew that a primary budget balance in line with its the debt-stabilising value was required, managed the public finances accordingly and, Hey presto! debt was stabilised.


Another surge in the debt level occurred as a result of the Covid-19 pandemic in 2020, with the debt level lurching upwards to 160% of GDP. Surely, now, Italy’s luck will run out? Surely, it will not be able to continue to stabilise the unsustainable?


Well, it seems it just might be able to. The reason is that Italy’s borrowing costs have plummeted, to just 0.5% pa for ten year borrowing.



Italy has proved to be a deft manager of its government finances for many years, stabilising what has often been regarded as a potentially unsustainable position. It has avoided the type of explosion in government debt seen in Greece and has not defaulted on its debt. But Italy needs to be careful. Periodically, the yield spread between Italian and German government bonds has widened out. In Greece, it was that widening of the yield spread which turned an initial concern about government finances into a full-scale crisis. The task of sustaining the unsustainable continues.



Notes to Chapter 4


[1] Alan Greenspan The Age of Turbulence Allen Lane (2007).

[2] This analysis was done many years before that by Reinhart and Rogoff, which put the problematic debt level at 90% of GDP. Reinhart and Rogoff Growth in a Time of Debt American Economic Association May 2010.https:// www.nber.org/papers/w15639

Their initial results were questioned by Thomas Herndon, a graduate student who had tried to replicate their findings. Reinhart and Rogoff had accidentally only included 15 of the 20 countries under analysis in their key calculation (of average GDP growth in countries with high public debt). Australia, Austria, Belgium, Canada and Denmark were missing. Furthermore, one bad year for New Zealand was given the same weight as 20 years of UK’s 2.5% growth while in the high debt category. https://www.bbc.co.uk/news/magazine-22223190

[3] One of the clearest examples of the political acceptance of the change was James Callaghan’s speech at the Labour party Conference in 1976. He said “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.” http://news.bbc.co.uk/1/hi/uk_politics/3288907.stm

[4] European Commission Convergence Report 1998. https://ec.europa.eu/economy_finance/publications/pages/publication8013_en.pdf

[5] Euromoney How Italy shrank its deficit 1 December 2011. https://www.euromoney.com/article/b1320nbmlzzpss/how-italy-shrank-its-deficit

[6] European Commission Convergence Report 1998.

http://ec.europa.eu/economy_finance/publications/pages/publication8013_en.pdf f

[7] Forbes Prodi sups with the devil, 21 September 1998.


[8] Otmar Issing on why the euro ‘house of cards’ is set to collapse Central Banking, October 2016.

[9] Prodi disowns ‘stupid’ stability pact The Guardian, 18 October 2002.

[10] Reuters Trichet’s letter to Rome 29 September 2011.


[11] Statement before the European Parliament, 1 December 2011. https://www.ecb.europa.eu/press/key/date/2011/html/sp111201.en.html

[12] Jean Pisani-Ferry The Euro Crisis and its Aftermath Oxford University Press (2014)

[13] Jean Pisani-Ferry The Euro Crisis and its Aftermath Oxford University Press (2014)

[14] IMF Fiscal Rules: make them easy to love and hard to cheat April 2018.