Italian Fever

Authors: Uri Dadush, Moises Naim
Originally published by L’Espresso

Is Italy the next Greece? No; it is not. In fact, Spain and other European countries are objectively more vulnerable than Italy. And so? Should Italians be content because the next shock to them will come not from Greece but from the crash of, say, Spain? Of course not. And that is the critical message that Italy’s government, its political, business and media elites better keep in mind: the main threat to Italy’s economic stability is neither Greek nor Spanish. The rather invisible but highly toxic virus that is undermining Italy’s economy is called complacency.

The fact that Italy has navigated better than others the recent economic hurricanes and now seems less likely to suffer a massive, Greek-like economic crash does not mean that Italy’s economic foundations are robust or that Italian policy makers can relax. Not only will the European neighborhood experience constant emergencies and economic shocks that will spill over and affect Italy but, more importantly, without urgent corrections Italy’s economy will evolve in ways that are bound to lead to a painful crisis.

This possibility can and should be avoided. The information, the tools and the policies are available and we discuss them below. But it is useless to have the policies if the need for them is not felt at the highest levels of government and by the rest of society and if politicians and other leaders continue to ignore Italy’s urgent need to strengthen its economic defenses. That alarm should prompt them to make compromises, work together and forge a common reform program. We are not naïve and know how difficult this is. But it will have to happen sooner or later. The more it is postponed, the deeper the pain will be for all Italians—especially for many who are still hanging on precariously to a middle class existence and the growing number of poor.

Italy’s recent economic “victories” should not obscure its fragility

It is true that Italy did a better job than Greece and others of managing its fiscal affairs during the crisis, that its current account balance and foreign debt are modest, that its banks did not need a big bail-out. It is also true that Italy’s reformed pension system, though still the most expensive in Europe as a share of GDP, is more sustainable than most because of the reduction in benefits accruing to those that will retire in the future. Italy’s government borrowing spreads vis-à-vis Germany’s have increased but have remained a fraction of those of Greece.

But it is equally true that Italy’s public debt is as big as that of Greece, that its demographic profile implies a declining labor force and rising costs for healthcare and pensions, and that Italy’s ability to compete internationally has deteriorated as sharply as that of Greece. Indeed, Italy’s productivity growth over the last 20 years was the lowest in the Euro area. Moreover the combination of high debt, bad demographics, declining competitiveness and anemic growth means that the Italian economy will remain exceptionally vulnerable to adverse economic shocks. These destabilizing shocks are almost inevitable in the highly uncertain post-crisis global environment.

The Italian economy suffers from three dangerous vulnerabilities:

First, a public debt near 115 percent of GDP. With interest rates near 4 percent, it costs about 4.5 percent of GDP a year just to pay for the interest. This means that, this year and next, Italian taxpayers will spend as much on interest as they spend in public education…if all goes well. If, on the other hand, lenders feel that the country is too risky, or interest rates rise again as is sure to happen with the global recovery, the costs will be much higher. If interest rates on government borrowing go up, the interest costs facing Italian firms and consumers will also become heavier. Moreover, even assuming that the government’s primary balance is zero (the primary balance is the difference between public sector revenues and expenditures, excluding interest paid on the public debt), the current interest cost alone means that the nation’s debt is growing faster than its economy in 2010. Without a big effort to take the primary balance firmly into positive territory, there is a serious risk that each year the debt burden will grow larger. Indeed, the consensus estimate is that Italy’s economy will grow at about 3 percent in nominal terms on average over the next seven years, a percentage point lower than the interest rate paid on its debt. And these are rather optimistic estimates because they assume that interest rates will stay near current levels, and that there will not be any accident in Italy or its main trading partners that slows down economic activity. Since Italy’s debt is of relatively short maturity, implying a relatively high financing requirement every year, Italy is potentially more vulnerable than other countries to a change in market sentiment.

The second vulnerability is the fact that Italy’s labor costs have become far more expensive than those of many of its competitors. This fact is both well known and a major threat to Italy’s stability and prosperity. In the last decade, Italy’s labor costs have become between 25 to 30 percent higher than those of German workers. The loss of competitiveness is even more dramatic when compared to wages in the United States, Japan, or China. These are all both large markets for Italian exports and the homes of the companies that compete with Italy’s exporters in international markets. The consequences of Italy’s lost competitiveness are massive and risk impoverishing all Italians: a recent comprehensive analysis of Euro area competitiveness by the European Commission concluded that, over 1998-2008, Italy’s exports of goods and services grew slower than all other members, that Italy lost the greatest part of market share in its traditional geographic markets, and that its market share fell by more than can be explained by cost considerations alone. While some Italian economists argue that quality improvements have allowed some Italian firms to charge higher prices, thus offsetting to some extent the loss of volumes, there can be no disagreement that Italy’s external balance has moved progressively into negative territory—despite the fact that the growth of Italy’s domestic demand has grown at the slowest pace in Europe over many years.

In today’s integrated global economy, it is impossible to grow at even a modest European pace without being competitive on world markets. Unfortunately, without vibrant exports, too many Italian companies will remain small and be unable to exploit the scale economies afforded by global markets. Because Italy has some of the weakest demographic and private consumption trends in the world, a focus on domestic markets is equivalent to slow growth.

The third central vulnerability results from the potentially explosive combination of the first two: they reinforce each other in a vicious cycle. It is very difficult to reduce a large debt burden if there is no growth. A larger economy can carry a larger debt by definition, or can afford the proportion of national economic activity that has to be devoted to pay interest instead of building schools and hospitals. And the expansion of the economy generates the additional tax revenues used to repay the debt. On the other hand, a large debt burden makes the competitiveness and growth problem worse because it raises interest rates throughout the economy. A large public debt also makes investors wary because they know the next tax rise is around the corner. In economies outside the Euro area, for example the UK today or Italy in the 1990s, devaluation to restore competitiveness and help growth through increased exports and reduced imports might have provided a way out of the vicious circle. But that is, of course, no longer an option.

Old dangers, new story

These vulnerabilities have been around for a long time and are well known to both experts and the public. But therein lies the problem: Italians have grown accustomed to living under the threat that these vulnerabilities can one day explode and unleash a maelstrom of damage. This “peaceful coexistence” with these clear and present dangers is no longer acceptable. The Greek crisis and its possible next stop in Spain or Ireland exposes how reckless it is to live in a home where the roof can fall on one’s head at any time. If this is not acceptable for a family, it is even less acceptable for an entire country.

This is not “more of the same”. This is a new situation where interest rates are responding to fears about sovereign debt levels and old habits have become dangerous.

For example, four possible storms can lead the roof to collapse on Italy’s head this year or the next:

• The spread of the Greek crisis to others will lead to a surge in interest rates that will spill over onto the private sector and kill the recovery in the weak Euro area countries, making the debt problem even worse. More unemployment, higher deficits and a further deterioration of public services and capabilities will ensue.

• A faltering of the global recovery as stimulus measures are withdrawn and sovereign risks and fragile banks spook markets.

• If, on the other hand, global growth is sustained, interest rates will rise from their historically low levels, and oil demand of emerging markets will continue to soar. Consequently, another large oil shock could hit the world sometime next year or in 2011 and trigger another global slowdown. Then Italy, the most imported-oil-dependent advanced country and the worst-placed to grow exports to pay for oil, will be hit especially hard.

• The most pernicious possibility is that Italy will continue to lose competitiveness against Germany and others, as wages rise faster than productivity and Italian firms are increasingly priced out of world markets or forced to relocate production to Eastern Europe or elsewhere. Unchecked, this process, which has been at work for many years, will eventually lead to a slow strangulation of the economy’s ability to grow at all. Financial markets will eventually react (or may anticipate the trend), forcing a Greek-sized surge in the cost of borrowing.

The point here is not to scare people, but to underscore the fact that shocks to Italy’s vulnerable economy could come from many different sources, and that even a sustained global recovery holds hidden dangers.

What to do?

Italy should not wait for the heart attack before dealing with its high blood pressure, excess weight, and smoking. Over the next three years, it needs to increase its primary balance by at least 4 percent of GDP to ensure that its debt/GDP ratio returns to a gradually declining path, thus reassuring markets that the nation has its long-term fiscal matters under control. By way of comparison, the primary balance improvement expected of Greece under its EU agreement is 10 percent of GDP over the same period.

Italy also needs to regain competitiveness, but with Germany’s unit labor costs not increasing (that is, in Germany, wage increases only happen if labor productivity increases) doing so requires that Italian unit labor costs decline – in other words Italian wages must grow less rapidly than productivity. By how much? A good start would be a six percent recovery of competitiveness over three years—about one quarter of the competitiveness lost against Germany over the last ten years. Even more important than the actual number would be the unmistakable signal that things are changing and that the deteriorating trend is being stopped and even reversed.

This effective devaluation could be achieved immediately through a six percent across the board wage cut, beginning, as in other countries, with public sector workers—though this is politically the toughest course. Alternatively, through a more gradual process of freezing wages over three years and enacting structural reforms that raise productivity by 2 percent a year above its recent trend. Because accelerating productivity over the short-run is tough, most likely is a combination of modest wage cuts and structural reforms.

Critical structural reforms would include removing rules that create a dual labor market where, while some are protected and cosseted, many others—ironically often the young and most educated—are forced to precariously hold on to low-paying jobs for years. Another crucial reform would be to increase the efficiency of backbone services that affect the competitiveness of all firms in the economy—energy, telecommunications, and transport. Yet other reforms among many needed would liberalize the retail sector and the market for professional services.

These domestic changes are essential and Italy needs to pursue them regardless. But, in addition, there is an important role to be played by Italy’s economic diplomats, beginning with those representing the country in Frankfurt, Brussels and Berlin. In a nutshell, they must break unequivocally from the German line and convey the message that adjustment in Italy and other vulnerable countries will be helped by a more rapidly growing Euro area. This will require Germany and other countries running a large trade surplus to commit to stimulating domestic consumption and investment, and relying less on exports to the rest of the Euro area. As we argued recently in the Financial Times, it is also indispensable that, even after the current global crisis has passed, the European Central Bank adopt a more expansionary monetary policy than the one it followed before the crisis—one that reflects the need for adjustment in large parts of Europe and not just the preferences of inflation fundamentalists.

Furthermore, during this crucial time, the European Central Bank’s explicit objective should be a weak, and not a strong, Euro in order to help stimulate the competitiveness of all of Europe.

Other countries in and outside Europe can also help. The G20, which is now the coordinating vehicle for international economic policy, and includes the giant fast-growing emerging economies such as China and India, needs to recognize that a sequence of sovereign debt crises in Europe would be bound to spill over onto some vulnerable emerging markets and could affect the borrowing costs of the Japanese and US governments, as well as everyone’s exports. In other words, such a crisis represents a large risk for a sustained global recovery. A lower Euro is the insurance premium the G-20 needs to pay to avoid implosion of the Euro area.

Who are more naïve, the reformers or the skeptics?

The reforms outlined here are painful and unpopular and would require great political courage—a commodity that is usually in short supply, and not only in Italy.

These proposals are easy to ridicule and dismiss, based on the fact that they ignore Italy’s political realities, the distribution of power and even the national culture. We know that. We also know that many years living in “peaceful coexistence” with dangerous economic threats and a precarious economic situation has created the strong illusion that whatever happens, in one way or another, Italy always ends up doing better than what catastrophist experts that don’t understand its real functioning regularly predict.

It is also a well known fact that Italy’s figures and statistics are quite opaque and that there is a “hidden economy” that is stronger, more dynamic and healthier than that reflected by the official statistics.

We strongly believe that this dismissive narrative ignores the facts about Italy’s dismal economic performance in recent years. It is also a dangerous narrative: it supports the complacency and passivity that create the policy stagnation that will sooner rather than later hurt all Italians. If nothing else, the crises in Greece and Spain underscore that changes in Italy, too, are inevitable. They will either come from a government and a society that find ways to work together to avoid their nation’s further economic decline or they will come as a result of ruthless economic forces. There are no easy, painless solutions. Waiting for them will only increase the pain.