If there was one major lesson that the UK government has learned over the past five years is that it is a mistake for a government to slash fiscal investment spending when interest rates are low. After all, if interest rates are heading to zero (or below), then virtually any investment that produces a return greater than zero will be worth doing.
When the Conservative/Lib Dem Coalition government took power in the UK in 2010, it pledged to save Britain from debt disaster by cutting spending and undertaking painful economic reforms. It was, they claimed, the medicine required after the heady days of the boom years had allowed debt-drunk households to overindulge.
The result, however was that it took over five years for the UK economy to return to its pre-crisis peak:
It remains the slowest recovery from a recession on record:
On the one hand the criticism of the Coalition's austerity policies has focused on whether they were necessary at all. As Professor Simon Wren-Lewis wrote in the London Review of Books (emphasis added):
By insisting on cuts in government spending and higher taxes that could easily have been postponed until the recovery from recession was assured, the government delayed the recovery by two years.
A delay of two years in the recovery meant more people out of work, which risked those people becoming de-motivated of de-skilled and threatened deeper lasting damage to the UK's economic potential.
But if the cuts as a whole weren't bad enough, they were implemented in such a way as to ensure that they had the most negative impact. That is, the Coalition's hike in Value Added Tax (VAT) drained money away from consumers while cuts to government investment held back projects that could have boosted the economy in the long term and helped the construction industry, which had been hammered by the recession, in the short term.
In other words, the policies were poor both in their overall conception and in the detail. And what it meant was that by the time the government began to reverse its cuts to investment spending in 2012, two years into its austerity programme, it had already squandered years of low interest rates (in part depressed by the Bank of England's purchase of government debt under its Quantitative Easing programme) that it could have used to borrow cheaply.
Surely then Europe should have learned from the UK's very public missteps?
Alas, it appears not. Matteo Renzi came to power in Italy promising to reform the country's sluggish economy by improving opportunities for young workers (Italy has youth unemployment of over 40%) and pledged to hold back the country's growing debt to GDP.
Here's how he went about it — slashing investment spending instead of addressing rising social spending (sound familiar?):
And he's been doing this while interest rates have been falling and GDP growth continues to disappoint:
As the rate of Italy's growth as fallen more swiftly than interest rates it pays on its debt, it now has to run a higher primary surplus (it has to raise in tax more than it spends) in order to keep its debt profile on a sustainable path. Moreover, with the spectre of deflation haunting the Eurozone (Italy's consumer prices fell -0.56% in January compared to a year earlier) Renzi is unlikely to be able to rely on inflation to erode the real value of the country's debt.
All in all Renzi would do well to learn the lessons of Britain's recovery. With the ECB poised to begin its own Quantitative Easing next month it looks likely that the Italian government's borrowing costs are set to fall even further. That presents it with a huge opportunity to unwind the mistakes of the recent past and start to use these low rates in order to invest for the future.
As a recent HSBC note puts it: "[Italy could] use part of the funds to increase productive investments. This could be done by increasing public investment in specific areas (eg transport, R&D), or unlocking investment projects that have been put on hold because of a lack of public funds."
Let's hope Renzi takes their advice. Repeat after me: Fiscal multipliers vary by instrument and over time. That is, when inflation is strongly suggesting you have a large shortfall of demand and interest rates are already at zero government investment is one of the most effective ways to boost growth.
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