Is this the end of populism in Europe?

Luigi Guiso, Helios Herrera, Massimo Morelli 25 January 2012

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The collapse of Silvio Berlusconi’s government in November 2011 leaves us relieved, even if it was after a protracted ‘death scene’ that brought Italy and the Eurozone to the very edge. Now questions arise:

  • How did such a populist government succeed in a western European democracy like Italy?
  • What are the economic costs of populism and how do they manifest themselves?

To answer these questions, a comparative look at Latin America can be illuminating, since populism has been more pervasive in that part of the world than anywhere else.

Latin American populism

Populism can be defined by two key features.

  • Consensus gathering based on promises of redistribution to the masses.
  • Concealment of government budget constraints from the voters.

These flourished in Latin America, mostly during boom times.

Populist governments that succeed in good economic times can easily implement public expenditure policies which are, in fact, procyclical, as a number of research contributions show (Akitoby et al. 2004, Kaminsky et al. 2004, Talvi and Vegh 2005). Indeed, in Latin America populism is widely understood as excessive public spending during booms. Obviously, fiscal policies should, instead, be countercyclical in order to fulfill the basic principle of consumption smoothing at the aggregate level and the idea of accumulating public sector precautionary savings as insurance against future recessions. Finding a procyclical pattern of government spending is even more shocking because, in developing countries, the business cycle is much more pronounced and volatile than in developed countries.

The Italian difference

Berlusconi, by contrast, first came to power during a period of protracted stagnation and diminished expectations – known as ‘Il declino Italiano’, or ‘the Italian regress’ – in the 1990s. Promises of redistribution, of protection from competitive pressure from global markets, and of lower taxes were granted precisely when they were most in demand. Italians were sold on Berlusconi's populist message when they were hungry, while the government budget constraint was being hidden from them. Excessive public spending followed. The primary surplus was 5.5% in the year 2000, and is currently virtually zero.

So why the difference? Why doesn’t Latin American populism fly in bad times, as it did in Italy? Let's consider the first question. A country like Italy, which always had easy access to capital markets and could place half of its huge public debt abroad, never encountered significant obstacles to financing its public spending through credit. Indeed, public spending increased constantly, despite the high stock of public debt. As long as financial markets remain friendly, populist excesses can be (or promise to be) the country’s public policy. Moreover, populist governments in rich countries can divert resources away from existing large public goods programmes – such as education and basic research programmes – which reap their benefits only in the long run, to finance short-term consumption and transfers – the types of expenditures that make voters happier today but make them cry in the future. In other words, populist governments in developed countries can fund their transfer policies by cutting back on investment. This could even be easier to hide from the general public than the government budget constraint.

In Latin America, excessive spending during recessions was followed by spectacular financial collapses. In the 1980s and 1990s, Argentina, Brazil, Bolivia, Colombia, Ecuador, Mexico, and Peru saw record hyperinflations due to excessive seigniorage or, in the absence of that, sovereign defaults due to excessive and non-payable foreign debt. Argentina in 2001, Uruguay in 2003, Paraguay in 2003, and Ecuador in 2008 are more recent examples, still fresh in our memory. These experiences seriously compromised the access of these countries to capital markets (Gavin and Perotti 1997).

Perhaps surprisingly, public debt in Latin America stands on average at around 50% of GDP, much smaller than in Europe. Populist excessive spending happens in Latin America at the only time it can happen – under a government surplus, when the government enjoys windfall profits from the sale of oil (as in Venezuela) or soy (as in Argentina), or some other commodity whose price and revenues are procyclical. But these windfalls are not saved and invested in long-term enduring projects to overcome some of the structural weaknesses of these economies. Instead, they are redistributed for current consumption. From this perspective – and answering the second question – populism is essentially the same in Italy and in Latin America. Both divert resources from long-term public good projects to short-term consumption, weakening the long-term growth prospects of their economies. Populism gives the illusion of short-term relief at no cost; the cost is just hidden or simply procrastinated.

The main difference is that in developing countries, the demand for populism is active both in bad and good times but has more chance of being satisfied – and, thus, its supply gains credibility – in good times. In developed countries, most people are well off most of the time, and can sustain their consumption needs easily. But when protracted bad times hit and their consumption habit is threatened, the siren of populism may becharm, as Italy’s story teaches us.

Concluding remarks

The key question we are left with today is whether the mindset of southern Europeans has changed after the experiences of these past few months. After their countries were brought to the brink of a financial collapse by populist policies, will Italians and Greeks again vote a politician into power who makes lavish promises in the presence of a recession? Among the many challenges facing Mario Monti and Lucas Papademos is that of teaching Italian and Greek citizens to be realistic again and not to trust illusory promises.

References

Akitoby,B, B Clements, S Gupta, and G Inchauste (2004), "The Cyclical and Long- Term Behavior of Government Expenditures in Developing Countries”, IMF Working Paper, October.
Gavin, M and R Perotti (1997), "Fiscal Policy in Latin America", NBER Macroeconomics Annual.
Kaminsky, G, C Reinhart, and C Vegh (2004), "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies", NBER Working Paper 10780.
Talvi, E, and C Vegh (2005), "Tax Base Variability and Procyclical Fiscal Policy in Developing Countries", Journal of Development Economics, 78(1):156-190.
 

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Topics:  Europe's nations and regions Politics and economics

Tags:  Italy, Latin America, Greece, Eurozone crisis