Reforms to Eurozone economic governance

The sovereign debt crisis that started in 2010 has triggered an unprecedented ‘existential crisis’ to the EU integration process (Jones, Reference Helgadóttir2012: 54). Its origins are compounded with the institutional limits of the political project that revolves around the monetary union (Baldwin and Giavazzi, Reference Baldwin and Giavazzi2015; Matthijs and Blyth, Reference Jones2015). As market pressures intensified, some sovereigns were priced out of the market, or lost market access altogether, and private borrowing costs diverged widely within the currency union – despite the common monetary policy (Allard et al., Reference Allard, J.C., F. Bornhorst, F. Ohnsorge and Poghosyan2013: 6). The crisis and its contagion also revealed that EMU rules were unable to ensure sustainable budgetary positions and prevent national fiscal policies from imparting adverse spillovers to other countries and to the union as a whole.

European policymakers responded to these challenges by reforming the governance of the Eurozone in a number of important respects. As the centerpiece of the EU fiscal governance framework, the Stability and Growth Pact (SGP) became the first target of reform.

Adopted in 1997, the SGP provides the framework through which to coordinate member states’ fiscal policies in a way that ensures fiscal sustainability while also encouraging economic growth. The SGP was originally built on three principles: the requirement for member states’ budgets to be ‘close to balance or in surplus’ in the medium term; a ceiling of 3% of GDP for the overall fiscal deficit; and a ceiling of 60% of GDP for public debt. Until 2011, only breaches to the 3% budget deficit target triggered corrective action under the excessive deficit procedure (EDP).

Before the sovereign debt crisis, the SGP had already been revised in 2005 following the political debacle associated with the breach of the deficit ceiling by France and Germany. In particular, the 2005 reform increased the flexibility of the fiscal rules by introducing the notion of country-specific medium-term budgetary objectives (MTO) (on the political factors surrounding the origins and evolution of the SGP see Heipertz and Verdun, Reference Goodman and Pauly2010). In 2011, the adoption of the ‘Six Pack’ legislation further revised the working of the SGP.Footnote ⁵ Among the major innovations, the new legislation introduces an expenditure benchmark to help assess progress toward the MTOs. The other major innovation is the operationalization of the debt criterion that had guided the fiscal framework since 1997: if the 60% reference for the debt-to-GDP ratio is not respected, the EDP will now be activated even if the deficit is below 3% (more on this below). The new legislation also tightens the EDP for Eurozone members by introducing reverse qualified majority for the adoption of financial sanctions.

The commitment to fiscal discipline was further strengthened through the adoption of the Fiscal Compact, which is part of an intergovernmental treaty known as the TSCG. The Treaty incorporates most of the commitments that had already being adopted through EU legislation, namely through the Six Pack. For instance, the Treaty incorporates the debt rule introduced under the Six Pack legislation. Under Article 4, Member States are required to reduce the gap in the level of public debt-to-GDP ratio to 60% by 1/20th annually. As anticipated, if countries fail in bringing down the debt ratios sufficiently quickly they become liable to the EDP.

Although it builds on existing legislation, the Treaty is also innovative in at least two important respects regarding the commitment to balance budgets and the correction mechanisms. First, the Treaty stipulates that a government’s annual budgetary position shall be balanced or in surplus, a provision also known as the golden rule. Specifically, Member States commit not have a structural deficit greater than 0.5% of GDP.Footnote ⁶ This commitment differs from those under the SGP where the lower limit to the structural deficit is 1%. Second, the Treaty strengthens the correction mechanisms in case of slippages from the structural balance budget rule. In particular, translation of the balance budget rule into national law must be done in a binding and permanent way, preferably at the constitutional level, and be monitored by an independent supervisory institution, such as a fiscal council. Furthermore, the Treaty sets up a mechanism of judicial enforcement centered on the EU Court of Justice (ECJ). Specifically, the ECJ is entrusted with the responsibility to assess members’ compliance with the provision of passing the golden rule into national law, if requested by one of the signatories. The ECJ can impose a fine of up to 0.1% of GDP in event of non-compliance with its decisions. Among the mechanism to induce compliance with the Treaty, it is also important to note that adherence to the Fiscal Compact is required for a member to have access to financial assistance from the European Stability Mechanism (ESM).Footnote ⁷

The Fiscal Compact was signed on 2 March 2012 by all EU member states with the exception of the Czech Republic and the United Kingdom. It entered into force on 1 January 2013 following ratification by the 12th Eurozone member state (Finland). The Czech Republic eventually adopted and ratified the Treaty in 2014.

While keeping the budget in order is certainly a useful recommendation for any government to follow, the constraints to budgetary autonomy contained in the new Treaty are not without problems. This is particularly the case for a country like Italy with the fourth largest stock of public debt in the world and around two-decades of stagnant economic growth.Footnote ⁸ Given its fundamentals, Italy will have to endure a sustained period of adjustment to comply with the new rules. For instance, the International Monetary Fund (IMF) estimates that fiscal effort for Italy will be five times larger than the consolidation needs that will be required in low-debt countries in the Eurozone (IMF, Reference Heipertz and Verdun2012: 39). As a result, it is not unlikely to conclude that adherence to the Fiscal Compact will ‘be the embodiment of permanent austerity’ in that it will require Italy to run a primary surplus averaging about 5% of GDP year after year (Münchau, Reference Monti2014). Even assuming the political sustainability of a such a demanding commitment, which cannot be taken for granted as the historical record indicates (Eichengreen and Panizza, Reference Edwards2014), its impact on growth is also debatable. Indeed, although the effects of fiscal consolidation on output depend on the design of fiscal packages, as well as on the coordination with monetary policy, simulations indicate that even under a ‘growth-friendly consolidation’ scenario,Footnote ⁹ ‘the output effects of required fiscal consolidation are sizable’ (IMF, Reference Heipertz and Verdun2012: 42). In particular, the required fiscal adjustment will translate into large output losses for the group of high-debt European countries, including Italy.

In short, economic fundamentals are a poor predictor for Italy’s stance in the negotiation for the Fiscal Compact. That is to say, a pure economic analysis is confounding because it sits uncomfortably with the empirical record: the Monti government ‘supported the Treaty, with a clear positive approach for stronger economic governance’ (Pierdominici, Reference Zoli2014). This puzzling negotiating stance thus needs closer theoretical and empirical scrutiny.

Vincolo esterno or market discipline?

The literature on international economic negotiations as well as scholarly works on the Eurozone crisis suggest two main explanations for explaining the disjuncture between a country’s structural position and its expressed preferences at the negotiating tables. The first emphasizes the normative orientations of the chief negotiators,Footnote ¹⁰ who are the Prime Minister and the Minister of European Affairs in the case under investigation. The second emphasizes the financial market constraints within which the negotiators operate. In what follow, I discuss both explanations with particular attention to the studies that have already examined how Italy behaves in EU-level negotiations. The discussion is meant to extract a set of observable expectations to be tested in the ensuing empirical analysis.

The normative-based explanation draws attention to the beliefs of the political actors in charge of the negotiations and the degree to which those actors are free to pursue their preferences given the relationship with domestic constituencies (for the original formulation of these arguments see Putnam, 1988: 488–450). Applied to our case, this argument would hold that the Italian negotiators, who were largely insulated from political and societal pressures because of the technocratic nature of the government of the time (Culpepper, Reference Conti and Verzichelli2014; McDonnell and Valbruzzi, Reference Pierdominici2014), supported the Fiscal Compact because they came to be believe in its underlying normative orientations. That is to say, Italian negotiators adhered to the view positing the expansionary effects of fiscal adjustment.Footnote ¹¹ Common education backgrounds and long-standing relationship between Italian and European policymakers could have provided the mechanism through which the Italian executive became socialized into this view and thus conceived of strengthened budgetary discipline as the preferred bargaining option (Helgadóttir, Reference Gray2015).

This line of reasoning has already been successfully applied to explain Italian policymakers’ negotiating stance in past EU negotiations. In particular, the socialization argument stands at the core of the ‘vincolo esterno’ hypothesis, which has famously been applied to explain the Italian negotiating position in the negotiations for the Maastricht Treaty in the early 1990s (Dyson and Featherstone, Reference Drezner1996, Reference Dyson and Featherstone1999; Quaglia, Reference Moschella2004). According to Dyson and Featherstone (Reference Dyson and Featherstone1999), for instance, Italian support for the Maastricht Treaty can largely be explained in light of a widespread belief among key governmental officials, namely key figures in the Finance Minister and the Bank of Italy. This belief held that Italy needed an external anchor to enforce budgetary discipline through a political system unable to generate necessary reforms internally (see Bull and Rhodes, Reference Bosco and McDonnell1997). This belief was so engrained and widespread among the governing elites to the point that it led to the conclusion that ‘there was no acceptable alternative to participation in EMU’ (Dyson and Featherstone, Reference Dyson and Featherstone1999: 465).

This belief became the building bloc of the Italian stance in the negotiations for Maastricht Treaty largely because the technocrats, who were the key supporter of the ‘external constraint’ thesis, were in charge of the negotiations and presented a cohesive front on the desirability of strengthening budgetary discipline (Quaglia, Reference Moschella2004). The cognitive convergence among Italian elites as well as their influence in the 1990s negotiations (and afterwards till the embrace of the common currency) needs to be read in light of long-term processes of institutional change in the country (Radaelli, Reference Münchau2002). At the time the Maastricht Treaty was negotiated, the Italian political system was in the thrones of a full crisis of authority and legitimacy, which involved the political parties but also the domestic institutions (Bull and Rhodes, Reference Bosco and McDonnell1997). The policy leadership of the technocrats was also helped by the fact that the Finance Minister of the time came from a technocratic background (Dyson and Featherstone, Reference Drezner1996: 274).

The parallels with the recent negotiations are easy to spot. The replacement of the Berlusconi government by the technocratic government led by Mario Monti ‘replays the pattern of the mid-1990s’, as Schmidt and Gualmini (Reference Radaelli2013: 380) have already noted. Political disarray and the appointment of cabinet members detached form political parties heightened the technocratic leadership during the negotiations (McDonnell and Valbruzzi, Reference Pierdominici2014). Furthermore, like the 1990s, the technocrats who led the negotiations in 2011–12 came to power with solid credentials for fiscal discipline. As will be illustrated at greater length below, Monti had been an outspoken supporter of Italy’s participation to EMU in the 1990s and had repeatedly emphasized the importance of keeping public finances in order in the domestic policy debate.

Extending the logic of the ‘external constraint’ explanation, the observable implications for the 2011–12 negotiations are as following:

If the ‘external constraint’ explanation implies deliberate actions to tie the government’s hands by domestic actors, the second explanation of governments’ preferences emphasizes the influence exerted by outside factors. Among them, the influence exerted by financial markets is the one that has probably received the most attentive scrutiny, as attested by the literature on policy convergence under conditions of financial globalization. This literature has showed that international capital mobility is the primary force that limits governments’ economic policy autonomy (Goodman and Pauly, Reference Garrett1993; Cohen, Reference Ceccarini, Diamanti and Lazar1996) leading to a convergence of policies of the like of smaller governments, social spending cuts, low levels of taxation, and low levels of regulation among others.Footnote ¹² The underlying assumption of this literature is that, under conditions of capital mobility, markets are reluctant to extend credit to countries that run persistent budget deficits or that impose high level of taxation for mobile factors of production. Hence, capital mobility induces a sort of ‘race to the bottom’: since investors are responsive to domestic policies in deciding how to allocate their portfolio, countries will be forced to compete on these policies in order to continue attracting capital (Simmons et al., Reference Sacchi2006: 792–793). The expected outcome of this competition for capital is likely to be convergence as countries choose policies that do not alienate market actors (for a critical review of this argument see, for instance, Drezner, Reference Di Virgilio and Radaelli2001). Competition, however, is not the only channel through financial markets impact on domestic economic choices. Capital mobility constraints domestic policy also through a ‘disciplinary’ mechanism, that is to say, through the rewarding of some actions and the punishing of others (Andrews, Reference Andrews1994). The punishment channel works primarily through the mechanism of market discipline or, more specifically, through the interest rate charged on government bonds (more below). A similar ‘disciplinary’ logic underpins the studies that attempt explaining why countries comply with the conditionality imposed by international institutions such as the IMF or the World Bank. In this reading, what leads domestic policymakers to agree on a curtailment of economic sovereignty often lies in the fear of exit by international investors and the credibility signal that an international financial assistance programs provide for those investors (Marchesi and Thomas, Reference Jones1999; Edwards, Reference Dyson and Featherstone2006; Gray, Reference Garrett and Lange2009).

Sacchi (Reference Quaglia2015) has recently extended the insights of the literature on financial globalization to the Italian case. In explaining why Italy adopted demanding labor and pension reforms in 2012, Sacchi draws attention to the external pressures exerted on the Italian government by both market forces and European institutions and countries. Specifically, structural reforms became the Monti government’s roadmap through the ‘operating mechanism’ of market discipline (Sacchi, Reference Quaglia2015: 78). Italian policymakers were thus somehow coerced into structural adjustment because market forces lent support to the reformist measures voiced by the ECB and heighted the credibility of the threat that creditor states might not be willing to provide financial assistance if needed.

Extending Sacchi’s argument to the case under investigation, it is plausible to hypothesize that, as market conditions deteriorated in the second part of 2011, Italian policymakers came to realize that they had no alternative but to signal the government’s commitment to fiscal discipline in order to calm the turmoil in Italian sovereign debt market and thus avoiding an escalation in the interest rates charged for selling government bonds. This leads to the following observable implications:

The road to the Fiscal Compact

From the adoption of the common currency, the Eurozone had achieved a very high degree of financial integration. The clearest evidence is the strong reduction in the dispersion of sovereign bond yields. Since 1999, the 10-year government bond spreads across Eurozone countries had become largely negligible (De Grauwe and Ji, Reference Culpepper2012). At the same time, current account deficits in peripheral countries were safely financed by private capital flows originating from within the Eurozone.

The crisis dramatically reversed these trends. Again, the clearest evidence lies in the pattern of the spreads of 10-year government bonds. Between 2009 and 2015, spreads widened significantly with peaks of around 350 bp at the height of the crisis in 2011–12 (Fondazione, Reference Ferrera and Gualmini2016: 2). Intra-euro area capital flows also came to a halt contributing to the economic contraction in deficit countries and to the dispersion of lending rates. That is to say, firms and households started facing different credit conditions according to the country of residence and not to their profitability.

Italy was drawn at the epicenter of the crisis in the summer of 2011 when the borrowing costs on its government debt reached all time highs. In particular, in late 2011, market pressures drove 10-year Italian government bond yields above 7%, a level that is generally associated with high default probability (Figure 1).

Figure 1

Interest rate, 10-year Italian government bonds (January 2011 to December 2012).

Intense market pressures interacted with domestic political stalemate, leading Silvio Berlusconi to give his resignation as Prime Minister (Bosco and McDonnell, Reference Emmott2012). Berlusconi’s step back opened the way to the creation of an emergency government led by the economist Mario Monti. The new government sworn into office on 16 November 2011 with a mandate to implement major reforms to rescue the country from its crisis (Di Virgilio and Radaelli, Reference Dellepiane-Avellaneda2013). Monti was thus the PM that led Italy into the negotiations for the Fiscal Compact following the agreement reached at European Council on 9 December 2011. In addition to Monti, who took on himself the responsibility as Finance Minister, the other key government officials in the negotiations were the Minister of European Affairs Enzo Moavero and the vice minister of finance Vittorio Grilli.Footnote ¹³

Technocrats were thus in the driving seat of European negotiations, similarly to what happened in the early 1990s with the Maastricht Treaty. In 2011–12, the technocratic leadership was accentuated by the features of the Monti’s government. As Valbruzzi and McDonnell write, the ‘Monti’s government stands out … because it was an extreme case of a technocrat-led government’ in terms of party composition and remit (McDonnell and Valbruzzi, Reference Pierdominici2014: 668). In addition to the insulation from the party system, the start of Monti government coincided with the breakdown and reconstitution of previous alliances among Italian parties (Ceccarini et al., Reference Bull and Rhodes2012: 57). Partito Democratico (PD) joined the Popolo della Libertà (PdL) in supporting the government, whereas the Northern League moved to the opposition. Political disarray thus combined with market pressures to heighten the leadership of the technocrats.

The Monti government was also a government that started the negotiations with strong pro-Europe, pro-fiscal discipline credentials, again very much in line with the normative orientations of the technocrats in charge of the Maastricht negotiations. Before becoming PM, Monti had served as European commissioner from 1995 to 2004 with responsibility on the Internal Market and Competition. Moavero had served as Monti’s chief of staff at the European Commission between 1995 and 2000. Furthermore, Monti was the Rector of the Bocconi University in Milan, an institution which have significantly contributed to the diffusion of the doctrine of ‘expansionary austerity’ (Helgadóttir, Reference Gray2015). Monti himself had been an outspoken supporter of fiscal discipline both in the early 1990s (Quaglia, Reference Moschella2004: 1102) and more recently during the Berlusconi government, as attested by his public pronouncements in support of a policy mix combining fiscal discipline and structural reforms to put the country back onto a sustainable growth trajectory (see for instance, Monti, Reference Matthijs and Blyth2011a, b).

In spite of its pedigree, the government’s stance toward the EU fiscal negotiations provide limited support to the view that Italian government members sought a new ‘external constraint’ in 2011–12, akin to the one that Italian technocracy sought in the early 1990s. Quite to the contrary, there was widespread recognition that tightened, external discipline was not necessary to induce the political system towards fiscal adjustment and it was not the best remedy to address the country’s long-term economic problems.

That the government did not conceive of the Fiscal Compact as a new ‘external constraint’ to push the Italian political system into action can be detected in several public pronouncements in which the country’s past efforts in fiscal stabilization are clearly acknowledged and endorsed. Speaking before Parliament on the developments in the intergovernmental negotiations, Moavero (Reference Marchesi and Thomas2012: 6) emphasized Italy’s ‘advanced stage’ in the process toward balanced budget and informed Parliament members that government leveraged on Italy’s fiscal efforts in its interactions with other European governments.Footnote ¹⁴ Speaking before the European Parliament, Monti (Reference Moavero2012a) endorsed the decision taken by the previous government to balance budget by 2013, well in advance of other EU member states. In other words, the government started from the assumption that Italy had already safely embarked on a process of fiscal restraint – implying that there was no pressing need for an external anchor to further push Italy in this direction. In an interview with the Financial Times, Monti (Reference Monti2012d) even suggested that ‘in my view the political parties will not dare go back to the acrimonious, superficial and tough confrontation that animated parliament. The image and style of the public debate has changed’.

If political dysfunctions were not the key motivation that led the Italian government to support the Fiscal Compact, a question can be raised of whether the signing of the Treaty reflects the normative orientations of the technocratic government. That is, support for the Fiscal Compact could be explained in light of the preferences held by key cabinet members, namely preferences that gave pride of place to fiscal discipline as a way to ensure sustainable growth. Again, the empirical record lends limited support to this view. Monti government never laid claim to the content of the Treaty. As Moavero clearly articulates this point before the Parliamentary committees: ‘Let me clarify at the outset that – as I guess you already know – the Italian government did not promote the Treaty under discussion’ (Reference Marchesi and Thomas2012: 4).

That Italian government officials did not act out of a strong preference toward fiscal discipline is also evident in the emphasis placed on growth as a counterbalance to the fiscal provisions contained in the Treaty. In an interview with the Financial Times published on 18 January, Monti (Reference Monti2012d) is reported saying that ‘Growth not austerity should be the focus of Eurozone policymaking’, hinting at the need to rebalance the policy mix toward measures to stimulate the economy as the first-best solution to attain macroeconomic stabilization. As Monti reiterated this point in several occasions, ‘growth is an indispensable condition for the sustainability of fiscal discipline in the medium-term’ (Reference Monti2012b).

Rather than prioritizing fiscal consolidation, the public pronouncements of the PM and the Minister of European Affairs are instead much more oriented at mitigating the impact of fiscal consolidation by prioritizing growth measures. In Monti’s words, ‘it is necessary to balance norms related to the discipline in public finances with norms that aims at promoting growth and competitiveness (Reference Monti2012b). Likewise, Moavero (Reference Marchesi and Thomas2012: 45) told Parliament that two of the three key objectives of the government’s strategy in the European negotiations (in addition to that of avoiding the fragmentation of EU law) were the objective of avoiding ‘enhanced discipline’ as compared to what had already been agreed in previous EU legislation and the objective of building up ‘a long-term perspective relative to the promotion of growth and competitiveness next to rigor and discipline’.

This is not to say that fiscal discipline was regarded as negative or useless. Rather, fiscal discipline is still regarded as ‘indispensable’ (Moavero, Reference Marchesi and Thomas2012: 4), ‘necessary and reasonable’ (Monti, Reference Monti2012b). At the same time, however, the terminology used by the cabinet members that led the negotiations reveals that there were serious concerns about the implications of enhanced discipline. For instance, in presenting the economic policy choices of the government, Monti (Reference Moavero2012a) described the fiscal obligations imposed on Italy as a ‘very tough constraint’. The PM even implicitly admits his reservations on the principles that underlie the new Treaty. For instance, discussing the path that led Italy to participate to the Fiscal Compact, Monti (Reference Monti2012c) observed that ‘whatever the government’s thinking’, his cabinet nonetheless decided not call into question the new rules that had been formulating at the EU level – a statement that suggests that the government might have had different views on the policy priorities to be followed.

If the logic of the ‘external constraint’ seems not particularly influential to account for the Italian government’s support to the Fiscal Compact, the influence exerted by market pressures is comparatively much stronger. Indeed, concerns about how markets would react (or over react) to a potential disengagement from the Fiscal Compact surface in the public pronouncements of cabinet members and, much more explicitly, in the interviews I conducted with the officials involved in the negotiations. For instance, virtually all interviewees mentioned the severe constraints imposed on Italy by the escalation of the financial turmoil in the government debt market since the summer 2011.

Similar concerns emerge in the public pronouncements here analyzed – albeit in a much more nuanced form than the one articulated in interviews (and comprehensibly so given that Italian policymakers were concerned about not alerting financial markets). For instance, Moavero justifies the government’s embrace of the new fiscal rules by appealing to ‘the extreme difficulty of the crisis that hinges on the country as a whole’ (Reference Marchesi and Thomas2012: 5). In other words, government members felt that ‘the context is one in which we have to signal our adherence to rigor’ (Moavero, Reference Marchesi and Thomas2012: 17). Given this ‘vulnerable situation’ as Monti characterized it, ‘we [the Government] concluded not to call into question this objective [the objective of balanced budget] because doing otherwise would have provided the image of a country that is not committed to fiscal discipline’ (Monti, Reference Monti2012c) – a statement that implies the risks that would have followed if the country would not have complied with the presumed markets’ preferences for fiscal consolidation. A similar concern can be detected in the observation that Italy had to sign into the Treaty because ‘it is necessary to project the image of a mature country that accepts a necessary and reasonable discipline, in reality and in the appearances’ (Monti, Reference Monti2012b).

In short, the Italian government supported the Fiscal Compact mainly out of punishment fears of adverse market reactions. The widespread perception of the country’s vulnerability nurtured a sort of ‘there-is-no-alternative’ mindset that dominated policymakers’ thinking and led them not to even conceive of the possibility of looking for alternative courses of action.

While the importance of financial market pressures cannot be underestimated, a question can still be raised of why policymakers came to perceive those pressures as so constraining. This question is particularly important if we take into consideration the pattern of interest rate premiums on Italian government bonds. After reaching its peak between November and early December 2011, the interest rate charged on the 10-year bond started declining – also because of the ECB refinancing operations (see also Zoli, Reference Simmons, Dobbin and Garrett2013). The Fiscal Compact was thus negotiated as markets were giving signs of normalization, albeit slowly and temporarily.

The question of the influence of market pressures on Italian policymakers is also interesting from a theoretical perspective. Several studies on the impact of market pressures on domestic policymakers indicate that these pressures do not act automatically but are often filtered by factors such as partisanship and the type of domestic coordination of economic activity (Garrett and Lange, Reference Fondazione1991; Garrett, 1998), national models of financial capitalism (Moschella, Reference Monti2011), and membership to international organizations (Gray, Reference Garrett and Lange2009) among the others. Hence, it is worth exploring whether Italian policymakers ceded to market pressures only because of potential punishment costs (e.g. increased interest rate on government bond yields) or because of the combination of other factors. From this perspective, it is interesting to note that the public pronouncements here analyzed point to three factors that might have acted in conjunction and reinforced the influence of market pressures. In other words, punishment was not the only mechanism that allowed market pressures to influence policymakers’ thinking and actions.