How Italy Will Change

Author: Uri Dadush
Originally published by L’Espresso

As Italians confront their most dangerous economic crisis, they fear for their future and their children’s. How will Italy need to change if this fear, which paralyzes economic activity, is to be overcome?

Based on the experience of other crisis countries thus far, Italians’ fear is justified by facts. Italian unemployment is up by forty percent since the crisis erupted, but the unemployment rate in Greece, Ireland, and Spain, where the adjustment is still far from over, has already doubled or tripled. Domestic demand in Italy is down five percent since its peak in 2007, but it has already fallen by between ten percent and twenty-five percent in the other crisis countries.

Do these comparisons apply? No one can know exactly. It is true that Italy has a smaller fiscal deficit and its banks are in better shape than any of these problem countries, but Italy has a high debt, has lost competitiveness and the capacity to grow, and, moreover, is in a much earlier phase of its adjustment.

So, let me be clear: Europe needs to help, but even with help, Italy faces big changes and, assuming all goes well, two or three difficult years lie ahead. The relevant question is how the inevitable hardship can be mitigated in impact and duration.

Everyone knows that Italy must restore its fiscal balance and reestablish growth. Achieving fiscal balance is tough, but reigniting growth in austerity and without devaluing is even tougher. In fact, it cannot be done quickly and a recession this year appears inevitable. However, given time, productivity can be boosted, resources can shift from the sclerotic public to the private sector, and from the moribund domestic sector—such as services and construction—to the traded sector, towards the world’s most dynamic sources of demand, especially to emerging markets. So Italy needs to step up its investment in machinery, tourism, design, other exportable services, and in food processing and agriculture. A big part of the difference between a dynamic Germany and a stagnant Italy is that the former’s share of exports in GDP has increased by seventeen percentage points of GDP since 2000, while the share of Italy’s exports in GDP has increased by just two percentage points.

How does one make sure these needed changes occur as rapidly as possible and in a way that minimizes the pain? Experience in both advanced and developing countries points to the following four lessons:

• Fiscal adjustment is less damaging to growth if it relies more heavily on expenditure cuts and elimination of waste than on tax increases which reduce everyone’s incentives to invest and to work.
• Taxpayers must share the burden equally, so tax evaders must be pursued vigorously while the poor must be sheltered.
• Employers in declining sectors must be allowed to downsize, while those in expanding sector should not be deterred from investing because of fear that they will be stuck with the workers they hire. The burden of adjustment should not fall disproportionally on young or older workers, or on those with temporary or precarious work arrangements. Wage moderation and shorter working hours will increase the likelihood that workers stay employed.
• Firms must compete, allowing prices faced by citizens and other firms to decline, moderating the fall in living standards and enhancing international competitiveness.

There is a connecting thread across these lessons—they entail reforms that are intrinsically equitable—favoring the people instead of specific groups.

For precisely these reasons, the reforms are already and will be increasingly resisted by special interests of all stripes—government agencies, firms, unions, and professions—who all benefit from the currently uncompetitive and inequitable system. So, expect Italy’s highly respected new government to come under more intense attack from multiple directions as the adjustment takes place. The political opposition meanwhile will bide its time.

Italy’s success will ultimately depend on whether its citizens—who know that there is no serious alternative to the current course—make their voices heard. They will be the drivers of Italy’s change.