6 June 2018
As a reminder that populist sentiment in Europe has not disappeared, Italy’s March election has finally produced an anti-establishment coalition between the Lega and the Five Star Movement (M5S), which appears willing to at least consider leaving the European Union as a remedy for the nation’s economic ills. On one level this is easy to understand, especially given the severity of the recession and tepid post-Crisis recovery. Likewise, ill-advised comments from German EU Budget Commissioner Gunther Oettinger combined with Italian President Sergio Mattarella’s rejection of the new coalition’s initial cabinet (because of the inclusion a stridently anti-EU Finance Minister) re-enforced the perception that the status quo does not reflect the wishes of Italy’s electorate.
However, will the coalition’s recently outlined economic strategy, which did not rule out leaving the EU/Euro club) improve Italy’s economic prospects? In short, while the plan may provide welcomed relief for some of the symptoms of Italy’s ills, it fails to address the economy’s deep-seated, long-term structural deficiencies. These issues, which existed well before the Euro’s creation, have impaired Italy’s inability to respond to the challenges of globalisation, and have impeded Italy’s recovery from the Global Financial (GFC) and Euro crises. Only policies addressing these issues will deliver the sustainable economic growth and prosperity sought by the Italian electorate. Leaving the European Union — either by design or as an unintended consequence of misguided policies — will only add to Italy’s list of woes.
RaisinG Living Standards: It’s All About Productivity!
It is easy to understand the frustration of the Italian electorate. The Chart at the top of the blog illustrates that Italian real per capita GDP has actually declined during the past two decades! Needless to say, Italy’s GDP growth has lagged well behind its European neighbours. And, while Italy’s under-performance preceded the GFC, the slump following the Euro-Crisis was amongst the most severe in the region. Furthermore, Italy’s economy has barely begun to recover. In contrast, both Spain and Ireland — also at the centre of the crisis — have already recouped the output lost during the recession.
Determining an economy’s long-term GDP growth potential is pretty straight forward: just add growth rates for productivity, labour force, and capital stock. To be sure, European productivity performance has been poor during the past two decades (as has been true world-wide). However, Figure 2 illustrates that Italian efficiency not only lags the region, but has declined sharply since joining the Euro. Comparing the first two charts delivers the unavoidable message: Italy’s growth dilemma emanates from chronic productivity weakness.
Weak productivity performance left Italy vulnerable as the pressures of globalisation intensified. The following chart illustrates unit labour costs in core-Europe have risen in line with those in Germany after the Euro’s introduction (as required). In Italy, however, these costs increased sharply prior to the Crises, again largely reflecting the nation’s weak productivity performance. Indeed, Italy’s involvement in the Euro-Crisis did not emanate principally from an overheated economy (as in Spain and Ireland) or fiscal profligacy (more on this later), but rather from this serious erosion of its competitiveness. While Italy appears to have prevented further losses recently, they have been unable to make up the ground lost — in contrast to both Spain and Ireland.
Poor productivity and flagging competitiveness have impacted economic performance in several important ways. First of all, real wages (and living standards) can only rise in line with productivity. The next chart again reveals that real incomes have declined sharply since the Euro’s introduction, and especialy during the Crisis period. Without income growth, consumer activity remains weak. The lack of a post-Crisis “feel-good factor” is unsurprising.
The following Charts illustrate that Italian exports have under-performed both before and after the Crises. Likewise, business investment, which collapsed during the recession, has yet to arise from the ashes. Both patterns are the legacy of poor productivity trends.
Ironically, despite Italy’s lack of competitiveness, the nation now runs a current account surplus of nearly 3% of GDP! This reveals that reflecting poor efficiency trends, weak domestic demand (consumption and capex) has curtailed the appetite for imported goods. Furthermore, the following Chart reveals that productivity performance is especially weak in domestically oriented sectors, which are less exposed to foreign competition. As these areas make up the bulk of the economy, it is hardly surprising income and spending patterns remain weak.
Labour Market Reform: Immigration is a Solution, Not a Problem
The World Economic Forum ranks Italy as the world’s 43rd most competitive nation (out of 137) — a poor result for the for the world’s 9th largest economy. The following Chart highlights the priority areas for reform. I will deal with the fiscal and banking sector issues later. However, at the top of the list of concerns are weak institutions (e.g. the legal system) and intense government bureaucracy and over-regulation. As highlighted earlier, productivity performance is worst in sectors of the vast domestic economy, which is precisely where regulations and government bureaucracy have the largest adverse impact.
In light of the populist political environment, the poor-performing labour market urgently requires reform — a view echoed by the WEF (amongst many others). The following chart illustrates job creation has lagged the rest of Europe during the past two decades. In addition, while unemployment is now declining, the rate remains above 11% — well above the pre-Crisis level of 6%. Joblessness also varies widely by region. In the Northern areas, jobless rates are 5% to 7%, while in the South and islands joblessness exceeds 20%! Youth unemployment is at a depression-like 32% level!! Over 26% of the youthful 15-34 year age bracket is descibed as NEET ( e.g. not in education, employment nor training) — well above the EU at 15% and the Netherlands at 8%.
Italy also confronts serious demographic challenges. Since 1970, fertility rates have been cut nearly in half — from 2.5 to 1.4 children per household. As a result, the population has stagnated, and has declined since 2015. The resulting weak labour force growth — a mere 0.2% annually in recent decades — will continue to limit the economy’s long-term growth potential into the future. The Chart above also indicates the population is quickly aging, which will put additional pressures on the already bloated pension system.
It is not surprising that populist Italian politicians seek to capitalise on high unemployment and poor job prospects, especially targeting the immigrant population. Indeed, the new coalition aims to deport 500 million immigrants, a meaningful share of the 6 million foreign-born residents. To be sure, Europe is grateful for Italy’s invaluable contribution in dealing with the earlier refugee crisis. However, the Lega’s policy appears especially misguided as immigration has the potential to defuse Italy’s demographic problem. Moreover, traditional metrics indicate Italy’s intake of immigrants is actually on the low side of the European average (Chart below).
Here are a few tips for a preferable labour market reform. First of all, focus on the large outflow of well-educated people leaving the country. Unlike past Italian emigration from poorer Southern regions, outflows now are rising sharply from Northern locations, especially among the well-educated (see Chart) — the Brain Drain! To be sure, the current mix of emigration of educated, young people combined with the immigration of low-skilled refugees is not ideal. Immigration reform is needed, not deportations!
Second, cut payroll taxes. The Chart illustrates that these costs — paid mostly by employers — are amongst the highest in the world. These charges hurt competitiveness and job creation. Finally, reform the wage bargaining system. Currently, pay deals are made on a sectoral basis at the national level, and do not reflect large regional productivity differentials. As a result, older workers get big pay gains, and the young are jobless. This system is also a major factor in the high unemployment rates in the Southern regions where efficiency is lower (and the emigration of under-paid, well-educated Northerns) .
Financial Policy: Growth Needed to Stabilise Debt Burden
Italy’s long-standing fiscal problems — government debt at 130% of GDP — are well-known. Post-crisis efforts to curb the red ink have been inconsistent, reflecting the volatile political environment. Nevertheless, the annual deficit has been cut in half since 2010 (from 4.2% to 2.1% of GDP). As a result, debt has stabilised (albeit at an undesirably high level), and the OECD projected a modest additional decline in the debt ratio under pre-election policies (next Chart).
The OECD’s “optimistic” projections, however, assume GDP growth of 1%, real interest rates at 1.7%, and the primary budget balance remaining at its current surplus of 1.5% of GDP . How likely are these assumptions to be met? First of all, the OECD debt projections highlight the crucial need for GDP growth to reduce the debt load. As the trend growth in Italian GDP growth is essentially nil, the growth forecast appears challenging. Likewise, the OECD’s real interest rate projection is not far from current levels. As the ECB normalises monetary policy, this assumption also will prove optimistic. So, even prior to the election Italy’s debt ratio was likely to drift towards 140% of GDP.
In this context, what will be the impact of the new coalition’s plan? The key features include reversing the agreed reforms to the pension system, a guaranteed monthly income of Euro780, introduction of a lower flat tax on personal incomes, annual tax deductions of Euro 3000, and scrapping planned excise/sales tax hikes. All in all, many estimates suggest these measures could boost the budget deficit by up to 5% of GDP. Needless to say, this would produce an unstable rise in the debt/GDP ratio into the future.
A full discussion of Italy’s fiscal dilemma is beyond the scope of this blog, but suffice it to say that failing to deal with the pension system would be disastrous. The chart illustrates that pension spending already represents 16% of GDP — twice the OECD average — and will rise as the population ages. Recent success in cutting the budget deficit relied on tax hikes, low interest rates, and cuts in public sector pay and capex. Meanwhile, the share of social spending inexorably increased from 40% to 50% of overall government outlays. Without pension reform, fiscal consolidation will prove impossible.
If this was not enough, Italy’s crippled banking system has the highest non-performing loans in Europe with the exception of Greece.
Strategic Implications
- Growth is crucial to remedying Italy’s fiscal and labour market woes. Not the “sugar high” that the coalition’s fiscal expansion may temporarily deliver. Rather, all reform efforts must focus on boosting productivity — the only source of sustainably higher living standards.
- Significant modifications of the coalition’s budget plan, especially the reversal of pension reform, will be needed to prevent a sharply higher debt ratio. At this stage of the economic cycle, financial markets are wary of policy mistakes. Markets have severely punished Argentina and Turkey recently for policy mishaps. I suspect the same will prove true in Italy. Avoid, sell rallies!
- The June EU summit will have a full agenda: Italy, Brexit, and Franco-German conflicts over the formation of a new Euro-land policy architecture. None will be easily resolved. European political uncertainty will be a tailwind for the USD, although US political risks will also increase prior to the November mid-term elections.