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Italy: The Real Effects of Inflation and Disinflation.

Monitoring the Journals

"Credibility, Debt and Unemployment:

Ireland's Failed Stabilization"

"Italy: The

Real Effects of Inflation and disinflation"

LIKE ALL COUNTRIES in West Europe, Ireland and Italy responded to the 1970s oil price shocks with increasing inflation. When regional inflation peaked in the early 1980s, these two countries set the record, Italy with a 21.2 percent annual increase in consumer prices in 1980, and Ireland with a 20.4 percent increase in 1981. Today both countries have returned to inflation rates close to the European, and international, average of 2 to 3 percent. These papers discuss the two most dramatic disinflation programs in West Europe. Four aspects are particularly interesting: the role of political crisis in the disinflation process, the significance of both countries' membership in the European Monetary System (EMS), the exchange rate arrangement with Germany (often appraised as a coercive device promoting monetary discipline in Europe), the combination of fiscal and monetary policies.

In fighting high and persistent inflation, policymakers must convince domestic wage and price setters that the announced changes in economic policies are serious and lasting. The experiences of Ireland and Italy show how credibility can be obtained by surviving domestic political crises. In Italy, an angry opposition and militant labor unions called for a national referendum against the government's change in wage policies in 1984. The referendum, in which the opposition was defeated, gave the government opportunity to show uncommon firmness in pursuing new policies. In Ireland, the decisive event was the fall of the government in 1983 over a stabilization-oriented budget. The new government passed the same budget with minor changes, thus demonstrating the growing political consent favoring a shift in economic policies. Labor-market and interest-rate data indicate that inflationary expectations began to turn around only after these political events. Policymakers thus had to demonstrate their willingness to accept the unpopularity of new policies before being regarded credible.

In contrast, and contradicting popular opinion, the authors argue that the external commitments of the two countries in the EMS were only secondarily important. Many have contended that by joining an exchange rate arrangement with low inflation, German countries can enhance the credibility of their own commitment and thereby reduce the real output and employment cost of disinflation. Both studies provide little evidence to support this view. Membership in the EMS had neither a sizeable impact on inflation expectations, nor did it reduce the cost of disinflation ralative to countries outside the EMS. However, the exchange rate peg in the presence of large inflation differentials with other EMS members resulted in overvaluations of both currencies, with the consequent losses in competitiveness in the European market, and, in Ireland, extreme unemployment. The Irish and Italian experiences cast doubt on the efficacy of exchange rate policies for promoting disinflation.

Drastic disinflation has important fiscal policy consequences. It reduces the part of the government deficit that can be financed by printing money. Furthermore, it raises real interest rates and thus the real cost of government borrowing. Disinflation therefore requires fiscal consolidation in line with the shift in monetary policies. But, as a restrictive monetary policy may cause a recession, fiscal contraction becomes particularly unattractive. The third common element of the two disinflations is that fiscal policies did not fully adjust in the required way. Italy and Ireland have witnessed increasing public debt to GNP ratios during the second half of the 1980s, Ireland's debt ratio now being one of the world's largest. Because a growing debt ratio cannot be sustained forever, the two countries now face the choice between more fiscal restraint or reflation. The ultimate success of both disinflation efforts is not secured until this choice has been resolved in favor of price stability.
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Author:von Hagen, Juergen
Publication:Business Economics
Article Type:Book Review
Date:Oct 1, 1989
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