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Friday, February 23, 2007

Italy's Economic Problems Under The Spotlight

As Manuel points out in his accompanying note, Romano Prodi's resignation as Italy's Prime Minister is a rather sudden and dramatic, but scarcely unexpected, development. The immediate political crisis may be resolved as rapidly as it appeared, but again as Manuel indicates it may only serve as a prelude for further things to come, and the fragility of any government coalition which may be put together only underlines the difficulties Italy will almost certainly have in addressing what are important ongoing economic problems. This brief note will simply attempt to outline some of the main problems, in order to contextualize the political problem a little.

The Deficit

First and foremost among Italy's immediate economic problems is the question of the government deficit. The debt to GDP ratio in Italy - which is currently somewhere in the region of 107% of GDP - is second only to Japan in magnitude, and the short term position has only been deteriorating of late, with estimates for the 2006 deficit being around the 5% GDP level.

All of this has, of course, placed Italy in somewhat bad odor in Brussels, and lead to the opening of an ongoing excess-deficit procedure from EU Economics and Finance Commissioner Joaquin Almunia under the terms of the revised Stability and Growth Pact. The seriousness of the situation hit the headlines last October when the credit rating agency Standard and Poor's downgraded Italy's credit rating from AA to AA-. All of this would come to have an even more ominous dimension if the situation continued and Italy's credit deteriorated further as the ECB has already indicated that should the grade drop below A, then they would cease to accept Italian paper as part of their reserves.

The upshot of all this is that the Prodi government adopted a fairly restrictive budget in fiscal terms for 2007 in an attempt to bring the deficit for this year down to within the 3% limit set by the EU SGP. Now this budget has been extensively criticised for it's shortcomings (and here, and again see the OECD view here), especially for the emphasis it places on tax increases and one-off measures over structural adjustments in expenditure as a way of addressing what are, after all, long term issues (shades of the German VAT hike here, except that in this case it is personal taxation for higher income earners which bears the brunt rather than consumer taxes), nevertheless it is obviously a step in the right direction, and what matters now is the follow-up, and especially the need for a major attempt to put some sort of order into the long run problems with the pensions system which in the context of the rapid ageing of Italian society (and here) is evidently not sustainable as it is.

And it is in this follow-up process that is precisely the issue in the current crisis, since there is no consensus at all on the need for these kind of reforms among the components of the Prodi coalition (which is why I feel the best outcome which could be expected from the crisis is the incorporation of the old Christian Democrats in the coalition, but again as Manuel indicates, it is far from clear that the left can tolerate this).

As Morgan Stanley's Vladimir Pillonca noted in a useful summary of Italy's current economic situation on the GEF back in January, the very good economic performance (at least by Italian standards, around 2.0% y-o-y, which was a significant increase on the lackluster average of 0.6% achieved during the years 2000-2005, but was still well below the eurozone average of 2.7% for 2006 ) attained during 2006 has had a positive impact on the short term debt dynamic. The trouble is that with most forecasts indicating a mild slowdown in global and eurozone growth this year, and lingering doubts persisting about the short term sustainability of momentum in Germany (Italy's chief export market) it is hard to see this dynamic being sustained across 2007, and any faltering of Italian growth will immediately begin put pressure on the underlying fiscal deficit situation and will once more raise the spectre of a further credit downgrade from Standard and Poor's.

Human Capital

Another preoccupying feature of Italy's forward looking situation is the net human capital balance that the country is sustaining. I have written extensively on this topic here (and here). The heart of the problem is that Italy has a substantial outflow of young educated people (as exemplified by the fact that the percentage of university graduates leaving the country in search of a brighter future is now running at some 4% of the total, up from 1% at the start of the 1990s). This situation takes on added importance in the light of the fact that Italy now has relatively few children (a Tfr of around 1.3) and in fact the Italian population stopped reproducing itself back in the early 1990s. To some extent this situation is offset by a large and steady inflow of migrants into Italy (which is to some extent responsible for the continuing buoyancy of the Italian economy) but I think it is important to think here about the human capital implications of what is happening. I think there is a general consensus among those who study the ageing societies problem that public finances are only sustainable in some of the worst affected societies if their economies manage to achieve a substantial move up the value chain into higher-value-added economic activities. Attracting migrants in substantial numbers to carry out low value work may help short term GDP numbers (as well as the government revenue position) and may indeed help correct some of the structural deficiencies in the population pyramid, but this alone will not turn Italy's welfare system and the associated funding issues from a unsustainable to a sustainable one. To achieve this target Italy needs to retain its talented young people, and put them to work in economic activities which are commensurate with their abilities. Hence the need for major reforms in the labour market, in the ease of setting up businesses (reducing red tape) and in the cost structure associated with the initiation of new types of economic activity.

And here again is another difficulty with Prodi's coalition, since one part of the coalition may well resist such changes ferociously.

Growth Weakness

As has been suggested above, Italy's growth problem is not a new one, and has been persisting for many years now. As can be seen from the chart below Italy's performance has substantially lagged behind that of the other main EU economies since the start of the nineties.

Indeed, as Italian economist Francesco Daveri points out in an extremely interesting podcast (Productivity Growth in Europe), Italy's growth rate has been steadily declining at about the rate of 1% a decade since the 1960s. Again this decline in trend growth has been associated with a steady stagnation in the rate of productivity growth, as Daveri outlines in this paper. Such is the downward secular tendency in Italian growth that it has really become impossible to clearly identify what trend growth is now in Italy, and thus it is hard to determine what part of 2006 growth is simply a temporary 'spurt' and what part is a real improvement in the underlying situation. Only 2007 will begin to make this point clearer. However it is obvious that if any real and lasting progress is to be made on this front, then substantial structural reforms are urgent.

Ageing and Saving?

Part of the issue with the immediate outlook for the Italian economy is the question of just what will be the propensity to save of Italian consumers and wage-earners from any forthcoming increase in income stemming from the recent comparatively good times and the apparent tightening in the Italian labour market (a tightening which is, remember, in part produced - as in the German and Japanese - and here - by the ageing process itself, since the larger number of workers to be found in the retiring older generations are not matched by equivalent numbers in the younger ones that replace them, although this tendency is in part offset by raised participation levels from young women in comparison with their older counterparts, but at the same time it is negatively affected by the increasing number of years spent in education before entering the labour market).

Claus Vistesen and I have already been addressing this ongoing weakness in domestic consumption in Germany and Japan, but it is worth pointing out that while the Italian State may be extraordinarily profligate, Italian citizens are not, and have a comparatively high level of personal saving (there is little in the way of a proerty boom to be found in Italy) as this report from McKinsey and Co outlines. So the most likely scenario is one of mid-term continuing weakness in consumption, and the best possibility for growth would seem to come from structural reform and growing export dependence.

The Outlook Going forward

As mentioned above Vladimir Pillonca offers a pretty balanced assessment of the immediate outlook for the Italian economy. Recent data for both consumer confidence and business confidence are certainly better than many (myself included) actually anticipated, and the Italian consumer appears to be remaining surprisingly robust (although we still need to see some real hard data for 2007, and we also need to see how the political crisis impacts on the confidence mood).

Also Italy seems to have begun to wake itself up to the advantages of a Japan/German style export-lead growth model, and there are serious moves afoot from Italian companies to try and leverage the opportunities which India seems to be offering (here, in Italian unfortunately). Confirmation of this tendency is already to be found to some extent in the recent data, which show that industrial orders have been moving up sharply on the back of significant rise in orders from abroad - 13.4% y-o-y in December, following a 6% m-o-m jump in November alone. So whilst there are evident downside risks (such as the impact of the VAT hike on consumption in Germany, the relatively high value of the euro, the fiscal tightening implicit in the 2007 budget, and the interest rate raising policy of the ECB), and while it is still impossible to see at this stage whether or not Italy will have a brush with recession in 2007 (due in part to difficulties in assessing capacity and trend growth movements at this early stage), there are evidently some significant positive elements at work - in particular those coming from corporate restructuring and the growing global export mentality of a core section of Italian higher-value-added industry (with the Fiat group notably taking the lead here), as well as from the growing numbers of migrants now working in Italy, who, as well as being employees remember, will also be customers and taxpayers.

Clearly the rapid rise of a number of the key developing economies (a process which, ironically, is significantly facilitated by the cheap interest rate environment produced by the presence of the "carry trade") offers important opportunities for Italy, Germany and Japan to thrive in the short term on export growth, it only remains to be seen (and to hope) whether or not these possibilities will be thrust asunder in the Italian case by a return of the old enemies of political instability, cynicism and pessimism.

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