What’s the most fiscally responsible country in the developed world?

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When you think about the developed world, says Larry Kotlikoff, don't assume Germany is the most fiscally responsible. Photo by Flickr user josemanuelerre.

When you think about the developed world, says Larry Kotlikoff, don’t assume Germany is the most fiscally responsible. Photo by Flickr user josemanuelerre.

Editor’s Note: Making Sen$e Social Security columnist Larry Kotlikoff recently returned from Rome, where he spoke with Italy’s new economic minister. From the outside, it’s easy to assume that Italy, with 13 percent unemployment, is in bad shape, beholden to the more economically stable Germany. But that’s a strange world, argues Kotlikoff, because Italy is actually in much better fiscal shape than its Teutonic brethren are.

— Simone Pathe, Making Sen$e Editor


Italy has a dynamic new prime minister, Matteo Renzi, whose last name should be Frenzy. In less than a year he’s made big changes to governance, dramatically liberalized labor laws, slashed short-term taxes on new hires, promised to halve the size of Parliament, and rekindled hope for his economically beleaguered country.

But Renzi needs help. He knows that Italy must invest, particularly in education, broadband technology and clean energy. Yet with unemployment at 13 percent, he dare not raise taxes. As for borrowing to invest, even when the investment will pay for itself, that’s a no no thanks to German Chancellor Angela Merkel’s enforcement of the European Union’s Stability and Growth Pact.

If only Italy could magically eliminate its outstanding debt, which exceeds 130 percent of GDP. Then Renzi would have the headroom to move Italy forward.

The Easy Way to Eliminating Debt

Actually, there is a quick and painless way for Italy to become debt free. Italy can simply buy back all outstanding government debt and pay for these bonds with commitments to larger future pension payments. Thus an Italian holding, say, €100,000 in government bonds, could swap them for, say, €101,000 in future pension commitments as valued in the present. The 1 percent grease, here, would give Italians an incentive to buy up all outstanding Italian government bonds and swap them all for higher pensions.

Sound crazy? It’s not.

Chile performed such a greased swap in 1980, but in reverse. It took back pension promises from workers in exchange for government bonds plus a kicker. More recently, Argentina, Bolivia, and Hungary have forcefully confiscated private pension assets (largely government bonds), swapping them for larger future pension commitments. And Poland, Estonia, Latvia, Lithuania, Romania and Russia are forcing workers to spend more of their new saving on pension claims rather than on assets, most of which would be government bonds.

Once he’s taken back all Italian government bonds, Renzi could stack them on top of 4,765-meter-high Monte Bianco and put them to the torch. This would let Germans, at least those in Bavaria, see with their own eyes that Italy was debt free.

If this proposal is making you queasy, it should. Swapping one liability for another of equal value doesn’t change a country’s total liabilities or overall fiscal position. Indeed, if the grease used to effect the swap is costly, the country ends up in worse fiscal shape. But swapping official debt for a liability with a different name does reduce outstanding official debt. And it is the size of official debt, not a country’s true fiscal position, that matters to the Stability and Growth Pact.

Suppose Renzi proposes doing what I advise. How will the Germans react? Not well. They will scream, “Foul! You are simply changing words.”

Where Italy’s Better Off than Germany

But Renzi has an easy answer. “You’re right. The Stability and Growth Pact is predicated on linguistics, not a county’s true fiscal condition. Let’s rewrite the Pact to limit spending based on a country’s true condition.”

Now the Germans will be stuck. For the only way to properly measure a country’s fiscal status is via its infinite-horizon fiscal gap. And on a fiscal gap measure, Italy is in far better shape than Germany.

“Economists have been slow to realize that the official debt and its annual change – the deficit — measures fiscal language, not fiscal policy.”

A country’s fiscal gap is the present value of all its projected future expenditure commitments net of all its projected future tax receipts. Whether the expenditure commitments are called one thing or another doesn’t matter to the fiscal gap. All commitments are put on the books.

Economists have been slow to realize that the official debt and its annual change – the deficit — measures fiscal language, not fiscal policy. But the profession is now clear on the point. Over 1,200 economists, including 17 Nobel laureates in economics, have endorsed www.theinformact.org, a U.S. federal law mandating infinite-horizon fiscal gap accounting by government agencies.

We’re Looking at You, Luxembourg

Fiscal gaps are measured as the share of GDP needed to be raised each year in additional taxes to permit the government to meet all its expenditure commitments through time, including those labeled “debt service.” The most recent measurement of EU fiscal gaps was done in 2012 for 24 member states by the European Commission. The results are shown in Table 3.5 of the European Commission’s Fiscal Sustainability Report 2012.

Luxembourg, ​w​ith its 9.7 percent of GDP fiscal gap, is in the worst shape of the included EU countries. The next biggest fiscal profligate is Belgium with a 7.4 percent gap. The Netherland’s 5.9 percent gap, the UK’s 5.2 percent gap, Finland’s 5.1 percent gap, and Spain’s 4.8 percent fiscal gap are also quite large. France and Germany, on the other hand, are close to fiscal balance with fiscal gaps of 1.6 percent and 1.2 percent, respectively.

As for Italy, its fiscal gap of negative 2.3 percent is the lowest of any of the 24 included countries. Indeed, Italy can spend almost €180 billion more and still be able to meet all its expenditure obligations. The source of Italy’s long-term fiscal solvency is its two major pension reforms that have dramatically reduced its pension obligations. In addition, Italy has strong control of its health care spending.

Europe’s Got Nothing on the U.S.

For the EU as a whole, the fiscal gap is 2.4 percent. That’s sizeable, but it pales in comparison to the current U.S. fiscal gap of 10.5 percent. It’s a strange word in which a totally bankrupt country — the U.S. — can borrow at extremely low cost while printing money at astronomical rates. It’s a strange world in which policymakers can’t distinguish economic from linguistic measures of fiscal sustainability. And it’s a strange world in which Italy, the developed world’s most fiscally responsible country, has to be lectured on fiscal prudence by countries in far worse fiscal shape.

Renzi is a bold leader. He should demand a rewrite of the Fiscal Stability Pact based on fiscal gaps. Failing that, he should fight linguistics with linguistics, swap unofficial commitments for official bonds, climb up Monte Bianco and set them ablaze​.

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