Public debt in Italy has risen steadily since 1976 and has now reached remarkable levels, while the economy seems to have escaped without damage. But market perceptions are crucial, Luigi Spaventa told a lunchtime meeting on 24 June, and this year there has been an erosion of confidence due to growing opposition to tax increases and pressures for liberalization of capital movements. The period of `benign neglect' of Italian public debt must therefore end, according to Spaventa: credible policy required movement from a primary deficit to a primary surplus by 1992, and detailed specification of the revenue and capital expenditure changes proposed to achieve this.
Luigi Spaventa is Professor of Economics at the University of Rome and was a member of the Italian Parliament between 1973 and 1986. The meeting at which he spoke launched the CEPR book, High Public Debt: The Italian Experience, published by Cambridge University Press and edited jointly with CEPR Research Fellow Francesco Giavazzi (see opposite). Spaventa is the Chairman and Giavazzi is a member of a consultative committee on debt management, appointed by the Italian Minister of the Treasury in May 1988.
Spaventa began by describing the background to the recent explosion of public debt in Italy, drawing on his introductory survey in the CEPR volume. At the end of 1987, Italy's gross public debt to GDP ratio was more than 0.92, 85% of which was debt on the market. These figures were remarkable, Spaventa noted, even though the historical analysis by Alberto Alesina in the volume revealed that debt had reached even higher levels in Italy (and in the United Kingdom) during previous episodes: the recent increase, however, was not the result of wars or prolonged recessions and had been almost uninterrupted. The major cause of this trend has obviously been the persistence of primary deficits. In addition, the burden of interest payments has increased so that the difference between the real interest factor and the real growth factor is now responsible for almost half the steady increase in the debt ratio of 4-5 percentage points each year.
It is difficult to specify exactly how debt growth has damaged the real economy in Italy, Spaventa noted. Growth and capital accumulation have on the whole been higher than in the rest of the EC; the current balance has not shown US-style deficits; even the lasting inflation differential has recently narrowed. Debt growth has, it is true, affected monetary policy and capital movements, as the chapters in the volume by Guido Tabellini and by Alberto Giovannini reveal. The freedom of manoeuvre of monetary policy has been hampered by its effects on the cost of debt service, and the existence of a large debt stock may partly explain the persistence of capital controls.

Economic theory provides an apparently weak criterion of solvency: over an indefinite period of time and as long as the real interest rate exceeds or may exceed the real growth rate, outstanding debt should be serviced (sooner or later) by primary surpluses. Theory provides little if any guidance on whether there is a `critical level' of debt ratio or whether and when there may develop a perception of insolvency.
Yet changing perceptions of solvency are a key element in the pathology of debt, Spaventa argued, and such a change has recently occurred in Italy. Growing opposition to further increases in the tax burden, in a country where tax evasion is so high, makes it more difficult to service debt by redistributing from taxpayers to bondholders. Domestic and international pressures have led to a gradual liberalization of capital movements. There has developed a growing disbelief in the government's ability ever to reduce the deficit.
This erosion of confidence was one of the causes of the recent difficulties in the primary and secondary bond market together with hesitant debt management, the effects of the introduction of a withholding tax, and the behaviour of banks. The result has been a shortening in the average maturity of debt (in 1981 the average life of debt fell below one year) and a rise in interest rates, exacerbating the contradictions between fiscal and debt policy and monetary policy. The markets have forced the government to realize not only that a debt problem exists, but also that continued inaction may lead to greater vulnerability to market perceptions.
Consistency and credibility should therefore now become the authorities' major objective, Spaventa argued, based on a gradual reduction of the primary deficit. The government has worked out a re-entry plan with the target of eliminating the primary deficit by 1992. While the plan is rigorous in its formulation, to be credible it should specify in greater detail the actions to be taken on both the expenditure and the revenue side. Though this should not be so difficult, political obstacles were not easy to overcome in a country where consensus is so often bought at the expense of the budget, Spaventa observed.
Fiscal improvements must be accompanied by changes and innovations in debt management, designed to make markets less volatile and to reduce the cost of debt. In his chapter in High Public Debt: The Italian Experience, Marco Pagano suggests that public debt instruments that are negatively correlated with the market portfolio will sell at a premium, and that their introduction would reduce debt service costs. Spaventa noted that in the late 1970s a major innovation in debt management was financial indexation, but demand for financially indexed bonds has since then dwindled, and the unsatisfactory alternative now is short-term bills. Other alternatives, such as fixed nominal rate bonds, long-term bonds indexed to the price level, currency-indexed bonds and greater recourse to foreign borrowing, should also find a place in debt management strategy.
Spaventa concluded his talk by dismissing proposals to solve the debt problem by non-market remedies, ranging from compulsory holding of bonds by the banks, to `consolidation', to monetization of the debt stock. Given that a primary deficit will persist for some years, policy will be increasingly dependent on the willingness of the market to finance borrowing, he argued.
In the discussion after the talk, it was pointed out that Italian public debt had until now been a purely domestic problem, partly because foreign debt comprised only 3% of the total; but how would this change after 1992? Spaventa argued that it would be possible for Italy to participate in greater European monetary unification, despite its high debt, so long as the government budget deficit is turned into a surplus. The full liberalization of capital flows by 1990 had already been accepted, he observed. But for as long as the deficits persisted, it was correct that the lira should be kept within wider margins, which had worked well in the EMS

HIGH PUBLIC DEBT: THE ITALIAN EXPERIENCE
Francesco Giavazzi and Luigi Spaventa, editors

Italy presents an almost perfect case study of the effects of high public debt. Debt has already reached 100% of GDP and will increase further, even under the most optimistic assumptions. Nevertheless, inflation, after peaking at 21% in 1981, has declined to 5% in 1986. Debt has grown rapidly, yet Italy has apparently not experienced any of the adverse effects of public debt growth predicted by economic theory.
CEPR's latest book looks at how financial markets and the private sector have found ways of adapting to high and rapidly increasing levels of public debt. It is based on a 1987 conference, the first of an annual series to be held at Castelgandolfo and organized by the Italian Macroeconomic Policy Group and CEPR.
In his introductory chapter, Luigi Spaventa surveys recent developments in the Italian economy. This is followed by chapters analysing monetary and fiscal policy, the impact of public debt on Italian financial markets and on household portfolios, and the relationship between debt growth and capital controls.
The volume will interest students of public finance, financial markets and economic development, as well as those concerned with the recent Italian experience. Contents include:
Introduction: Is There a Public Debt Problem in Italy? by Luigi Spaventa
The End of Large Public Debts by Alberto Alesina
Monetary and Fiscal Policy Coordination with a High Public Debt by Guido Tabellini
The Management of Public Debt and Financial Markets by Marco Pagano
Capital Controls and Public Finance: The Experience in Italy by Alberto Giovannini
Public Debt and Households' Demand for Monetary Assets in Italy, 1970-86 by Andrea Bollino and Nicola Rossi
High Public Debt: The Italian Experience (ISBN 0-521-35635-0, 276 pp.) is available for £25.00 or $44.50 from Cambridge University Press