October 24, 2006
Fiscal tightening and reform can rescue Italy’s economy
Being prime minister of Italy is not much fun. Last week’s downgrading of Italy’s government debt by Standard & Poor’s and Fitch Ratings must seem just another blow to a government that won a narrow election victory and has since seen its support in opinion polls slump. Yet appearances may be deceiving. Italy needs such shocks if it is to put through the needed policy changes.
The analysis by Fitch Ratings presents a dismal story.* Over the past five years, gross domestic product has grown at a compound rate of just 0.6 per cent a year. In contrast to Germany and Japan, Italy’s weak growth is also, in substantial part, the result of deteriorating external competitiveness. Domestic demand has grown by about 0.4 percentage points a year faster than GDP since 2000.
Because Italian inflation has been somewhat higher than Germany’s, monetary conditions have been relatively supportive, with real short-term interest rates averaging around zero since 2000.
The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.
Tito Boeri: I agree with the analysis. Just two rather minor clarifications.
First, the new downgrading is unrelated with the increase of the debt-GDP ratio in 2005 and 2006. The increase in 2005 was known already in March 2006 and the 2006 outcome is due to one-off expenditure related to the decision of the European Court of Justice to cancel a VAT tax. This is highlighted by the difference between the expected 2006 deficit on a cash basis (3.2 per cent of GDP) and on a commitment basis (4.7 per cent).
Second, the decline in labour productivity is also a byproduct of a large increase of the Italian employment rate. As pointed out by the column, the still large unused capacity of Italy is an important asset. I would add that this unused capacity makes the risk of default very unlikely for a country like Italy.
Posted by: FT Forums | October 25th, 2006 at 5:38 pm | Report this commentMartin Wolf: I have no disagreement with Tito on his second point. There is also an additional point that I did not make in the original column, namely, that the performance of exports in terms of value was much better than in terms of constant prices. It is suggested by some analysts that the inflation element in export prices may be significantly overstated and quality improvements correspondingly understated. In that case, Italy’s poor export performance (in real terms) and loss of export competitiveness would both be significantly exaggerated.
On Tito’s first point, this is what FitchRatings writes: “Until recently concerns about the high level of debt had been mitigated by its persistent and firm decline over time, a profile which provided an important cushion against shocks. However, with debt now having risen for two consecutive years and unlikely to decline very rapidly over the medium term due to weak growth prospects and difficulties in implementing fiscal adjustment, sovereign vulnerability to shocks have risen.” This indicates that the increase in the debt ratio in 2005 and 2006 was indeed a factor in the recent donwgrading, even if mistakenly so.
Posted by: FT Forum - Martin Wolf | October 26th, 2006 at 6:27 pm | Report this commentRobert Wade: The other day I travelled into Manhattan in a taxi driven by an Indian who had lived for the previous six years in Italy, near Ancona, as a shoe designer. But six months ago the factory closed, like many other shoe factories in the region. Chinese firms, he said, were employing Italian shoe designers at very high salaries to work alongside Chinese managers employing limitless numbers of Chinese women to make identical shoes as the Ancona ones with identical Italian equipment - for a fraction of the cost. So New York got yet one more Yellow Cab driver.
As Wolf says, Italy specialises in industrial sectors where demand is least dynamic and low-cost Asian producers are most competitive. He goes on to say: “The only solution is improvements in labour productivity in tradable goods and services, through layoffs and product upgrading.” The policy conclusion? “What the country needs…is a strong government that pursues reform ( = liberalisation of labour, service and product markets) and fiscal retrenchment with gusto”.
By emphasising market liberalisation plus macrostability as the keys, Wolf presumes that the needed sectoral diversification will happen fast enough “by itself”. His is a more specific version of the prevailing presumption that provided a government creates a “level playing field” the players will turn up to play.
I wonder whether a more active and coordinated supply-side push for diversification and product upgrading could be more helpful than Wolf presumes (in the sense of producing larger social benefits than social costs). I have in mind something like an “industrial extension service” whose job it is to encourage firms to diversify and upgrade, by providing information, coordinating, motivating and perhaps even authorising limited, targeted and sun-set-claused financial incentives. It is odd - here referring to the general situation, not just Italy - that just about everyone accepts the desirability of an agricultural extension service, but the idea of an industrial extension service (IES) gets little support. The IES could be joint public-private (business confederation); and certainly in the Italian case it would have to be organized by regional governments, not the national government.
Of course, to even hint at some sort of “industrial policy” for Italy is to invite the hurrumph that Italy is Exhibit A of failed industrial policy - the long-term development strategy for the South (Mezzogiorno), the main effect of which, it could be argued, was to enable southerners to flock to northern factories on the new highways and northern goods to move in the opposite directions. But I am not talking about the Mezzogiorno stragegy, which was a “picking winners” kind of industrial policy. “Picking winners” is all too often presumed to be the whole of industrial policy, and since, as everyone knows, “bureaucrats can’t pick winners”, the presumption justifies instant rejection of the whole idea of industrial policy.
Whatever one’s judgment about the efficacy of “picking the winners” type of industrial policy in East Asia (of which Howard Pack is a leading critic, see Pack and Kamal Saggi, “The case for industrial policy, a critical survey”, Policy Research Working Paper 3839, World Bank, Feb 2006), East Asian countries have also used the sort of “get in behind” industrial policy I am referring to. Industrial policy agencies, such as Taiwan’s Industrial Development Bureau and the Factory Automation Task Force, have sent out their staffs of industrial engineers, organized in sector teams, to nudge firms to diversify, upgrade, switch to domestic suppliers and away from imports, month after month, decade after decade. In turn they contribute to discussions at the “macro” level about appropriate directions for economy-wide diversification (eg which types of robots offer good prospects for Taiwan-based firms?). Pack’s measures of effectiveness don’t pick up efforts of these kinds, and if one presumes that only what is measurable counts one dismisses such efforts as trivial and not to be recommended elsewhere. But if … See my book, Governing the Market (2004).
Like it or not, all governments operate implicit industrial policy through their decisions as to which sector-specific public inputs to provide and which not (and how much). It can be argued that when an economy like Italy faces an urgent need to diversify its sectoral mix within industry and services the decisions about the supply of sector-specific public inputs - and hence about the directions of diversification - should be made through networks linking public and private bodies, including an IES. Ricardo Hausmann, Dani Rodrik and others at the Kennedy School, Harvard University, are doing interesting research on the question of how to decide appropriate directions of diversification.
Posted by: FT Forums | October 29th, 2006 at 2:05 pm | Report this commentAnne Sibert and Willem Buiter: Are Fitch and Standard and Poor’s right that it is now somewhat more likely that the Italian state will default on its debt? The state is solvent if its outstanding debt does not exceed the present discounted value of its expected future primary budget surpluses. We can restate that it in a way that emphasises the four crucial parameters determining the solvency of the state: (1) the ratio of the outstanding stock of public debt to GDP; (2) the permanent share of the government’s primary budget surplus in GDP; (3) the long-run real interest rate; and (4) the long-run growth rate of real GDP (the permanent primary surplus to GDP ratio is the expected long-run future average value of that ratio). The Italian state is solvent if the ratio of the outstanding stock of debt is not greater than the permanent primary surplus as a share of GDP, divided by the long-run real interest rate minus the long-run real growth rate of GDP.
The reasons for concern are obvious. Italy’s net general government debt in 2006 is 106 per cent of GDP. This is one of the highest in the world and compares with figures of about 55 and 64 for France and Germany, respectively. The nominal interest rate on 10-year Italian government bonds is about 4 per cent and the annual growth rate of real Italian GDP has averaged 0.65 per cent over the period 2001–2005. If future interest rates and GDP growth rates are similar and if future Italian inflation is about 2 per cent per annum, then the Italian real interest rate minus real GDP growth will be about 1.35 per cent. Thus, if Italy ran constant government primary budget surpluses as a share of GDP, they would have to be over 1.4 per cent for Italy to remain solvent.
The OECD estimates that Italy’s structural primary balance was 0.4 per cent of GDP for 2005 and 2006. This is not sustainable, but if our figures are correct Italy is only a permanent correction of 0.95 per cent of GDP way from solvency. So what’s the fuss?
One reason for worry is that risk-free interest rates in the eurozone are extraordinarily low at both the short and long ends. A correction of this anomaly could easily add a percentage point to medium and long-term eurozone-wide real interest rates. Each one percentage point increase in the average risk-free cost of borrowing will require over a 1 per cent increase in Italy’s long-run average permanent primary surplus as a ratio of GDP.
The vulnerability of the sustainability of Italy’s fiscal position is further enhanced by the risk of a vicious circle increasing the default risk premium (still only 27bps over 10-year bunds) that Italy’s government pays on its debt. If the market looses confidence in Italy’s government’s ability to generate sufficiently high surpluses, Italian interest rates will rise, increasing Italy’s public debt burden. This will require even higher surpluses and lead to further losses in market confidence. A government with a debt burden as high as Italy’s is always dancing on the edge of a volcano.
What are the options? Leaving the eurozone for a short-run competitive gain would be mad. Higher cost and price inflation would soon undo this benefit and leave Italy with a permanently higher stock of debt and increased interest rates on new borrowing. Existing debt is denominated in euros and would remain so. The collapse in the value of the lira would produce a massive increase in the Italian public debt-to-GDP ratio. New debt would be denominated in new lira and would pay pre-accession Italian interest rate or worse.
Instead, Italy must cut unproductive government spending and pursue aggressive economic reform. Public spending as a share of GDP in Italy is 48 per cent, compared with 35 per cent in Ireland: there is ample room for reduction. Italy has the most regulated product markets in the the eurozone and the World Bank rates Italy number 82 in the world – behind Kazakhstan and Nicaragua – in its Ease of Doing Business index. A 2 percentage points of GDP increase in the permanent primary surplus, coupled with an increase in the GDP growth rate to 1.5 per cent per annum ought to restore Italy to fiscal health, even if Euro-area interest rates rise to more normal levels. Unfortunately, in recent years Italy has shown little inclination to enact the required fiscal and regulatory measures.
Posted by: Willem Buiter, London School of Economics | October 29th, 2006 at 5:42 pm | Report this commentMartin Wolf: Robert Wade, and Anne Sibert and Willem Buiter have enriched the debate on Italy in very different ways. I am in agreement with the latter two. They have elaborated the solvency analysis and so strengthened the policy conclusions.
Robert raises the interesting question whether policy could help accelerate the upgrading and diversification needed by Italian industry (and the Italian economy), if it is to remain internationally competitive, while paying the wages Italians expect. In an earlier draft of my column I discussed some of the longer-term policy requirements. (Space limits made it necessary for me to drop these sentences.) Among these, in my view, are better funding and re-organisation of universities as both educators and generators of research. I also believe greater inward foreign direct investment should help.
Whether an “industrial extension service” would also be useful I don’t know. I would doubt it. My impression is that Italian business is justifiably suspicious of the quality and sometimes even the probity of government services, at whatever level. Given that, they will probably look on the proffered help in much the same way as the Trojans were encouraged to look upon Greeks bearing gifts.
I am not unalterably opposed to industrial policies of this kind. I merely believe that the circumstances in which they work are special. Among the requirements is an honest, capable and, above all, trusted public administration. It is also easier, I believe, if a country is not close to the global productivity frontier, as Italy is. Italy is an advanced country with unique characteristics. That makes predicting its future comparative advantage incredibly hard.
Posted by: FT Forum - Martin Wolf | October 30th, 2006 at 7:51 pm | Report this comment