Italy's Supply Constraint

The OECD estimates the current potential capacity growth rate of the Italian economy at 1.25% a year. Actually I suspect even this very low number is over-optimistic. Growth since 2002 has been as follows: 2003 - 0.1%: 2004 - 0.9%: 2005 - 0.1%. To be sure forecast growth for this year is somewhat higher, at 1.4%, and optimists are expecting this to be more or less repeated next year. But I suspect this outcome is unlikely simply because the global economy now seems to be slowing (and in particular the ever important US economy),so the strongly advantageous situation of 2006 is unlikely to be repeated, while next year the Italian government has promised to introduce an important package of spending reductions which are bound to negatively affect growth, at least in the short term..

But why is potential growth capacity in Italy so low?

Well, as you might have imagined, my focus here will be more or less on the limited capacity for Italy to increase the size of its workforce after 20 odd years of low fertility. In this sense this post is a practical case study of my more theoretical "Of Population Pyramids and Value Chains". Now again according to the OECD:

With employment rising by only about ½ per cent per year, there should be some recovery of productivity, in turn accentuating disinflation and facilitating export growth. Without bold structural reforms by the new government to raise the economy’s low supply potential and reverse its huge cost disadvantage......... sub-par growth is likely to persist.

This again is just one example of why I was so tenacious in the comments on the recent 'Reform Has Become A Dirty Word' thread. Italy urgently needs reform. And it is because of the apparent difficulty that Italy has in carrying out reform that I am so adamant that Italy may well reach a situation where it has little real option but to default on the public debt, with all that this implies. Indeed Italy seems set to become the 'test bed' of how the ageing process works out in practice.

Of course the 'drying up' of the labour supply in Italy which is reflected in this low potential growth estimate is producing historic lows in the Italian unemployment rate (a phenomenon we are also seeing in Japan):

Italy's unemployment rate fell to the lowest in more than 14 years, a government report showed today. The unemployment rate fell to 7.0 percent in the three months through June from a revised 7.3 percent in the first quarter. That was the lowest the statistics institute started its survey in 1992. It was expected to remain at 7.3 percent, according to the median forecast of 23 economists in a Bloomberg News survey.

Italian joblessness has fallen to the lowest of the euro region's four-largest economies even though growth has averaged just 0.6 percent in the past five years. The expansion in Italy's $1.8 trillion economy will lag behind that of the euro region for at least a 10th year in 2006, expanding 1.7 percent, compared with a 2.5 growth rate for the 12-nation bloc, according to the European Commission.

So what we have in Italy is pretty low unemployment, and a miserable growth record, strange isn't it? Even stranger perhaps is the fact that most economists don't seem to be giving much importance to thinking about just why this is happening.

The latest data from the Italian Statistical Office ISTAT is interesting (in Italian only unfortunately), since it shows that, year-on-year, the number of people actively seeking work declined to 1.621.000 which was a reduction of 11.8% (or 216.000 people) over the second quarter of 2005. And this situation has only produced an annual estimated growth rate of 1.4%. Put simply, this is because - without a significant change in participation attitudes, especially among women (and which is, in part, what the reforms are about) - Italy's available workforce is now set to decline.

Of course Italy is creating new jobs, but as Bloomberg point out, to a great extent it needs immigrants to do the work:

More than 30 percent of the rise in registered employment in the quarter and almost 40 percent of the increase in the past year came from immigrant workers, the national statistics institute said today in Rome. Many of these registered jobs are low-skilled positions, meaning the economy isn't as healthy as the numbers might otherwise suggest.

The statistics show that the biggest gains in registered employment have come from immigrants gaining legal status, many of whom are already working. More than 900,000 foreign immigrants, the equivalent of almost 2 percent of the population, have won residency in the past three years through a series of government amnesties.


Italy's position is in fact even more complicated since the recent employment growth is largely in low skill activities (which means that if Italy is moving up the value chain it is in fact doing so very slowly, far too slowly for its needs):

``I've worked at unpaid internships for years, but the number of jobs out there isn't growing,'' said Carlo Massoni, 32, who's only been able to land short-term contract work since earning a degree as a telecommunications engineer six years ago.

``I haven't had a break since I graduated.''

The number of workers with non-permanent contracts grew 8 percent in the second quarter and those short-term contracts now account for 9.5 percent of total employment, up from 9.0 percent a year earlier, Istat said today.

The lack of permanent job opportunities has left Italy with the second-highest youth jobless rate in the European Union after Greece, currently 24.1 percent of those aged between 15 and 24. Almost half the increase in registered employment in the first half came from people over the age of 50, Istat said.

So those seeking work in low paid unskilled jobs are finding them, whilst those who are young and qualified seem to be finding the going tough. Something somewhere is going very wrong here.

And even if the Italian economy did finally manage to break into more new sectors the supply problem still exists, since a very significant proportion of Italians in the 25 to 34 age group have very low education levels. Again lets look at what the OECD had to say last year:

Compared with other OECD countries, an above-average proportion of the Italian population has only lower-secondary education. This is especially true for older age-groups, but it is also true for younger ones. Forty per cent of 25-34 year-olds are in this category compared with an EU and OECD average close to 25%, and the results of the OECD Programme for International Student Assessment (PISA) show that Italian 15-year olds have attainments well below the average in particular in mathematical and problem-solving skills. There is a high proportion of youth which is in neither education nor the labour force, suggesting a difficult school-to-work transition. The risk of unemployment later in life is also considerably higher for those with only lower secondary education.

Furthermore, a smaller proportion than the OECD average has completed tertiary education, even though a relatively high proportion embarks on it. Years spent in obtaining an undergraduate degree are greater than the average, raising the opportunity cost of tertiary education and discouraging the formation of high level skills. The demand for high-skill workers may be hampered by the specialisation of Italian industries in low tech sectors and the small size of Italian firms, which reduce their R&D spending capability. At the tertiary level, a problem is an insufficient number of younger professors, for whom there are barriers to entry. Academic appointments lack transparency, promotion is not always linked to productivity, and Italy spends far less than the OECD or EU average on research and development, and significantly less on tertiary education. As a consequence Italy suffers from a pronounced net brain-drain.

So there we have it. Italy seems to be caught in a very strange kind of trap, where a very inefficient education system means that only a small proportion of young Italians stay the distance to get their final qualification, and as a result there are insufficient qualified people to help make that much-needed leap upwards. And even if Italy was succesful in attracting a large number of older women into the workforce (but in which case who would look after the increasing number of dependent old people?) this wouldn't resolve the problem, since the low educational level would strongly constrain the kinds of work which they could do. As I say, a strange kind of trap.

De Gregorio Defection: More Problems

Following hot on the heels of the opionions expressed by George Kopits(see my last post)to the effect that:

The new Italian government is composed of a loose coalition of divergent political parties holding only a razor-thin majority. Any initiative to reduce the budget gap through spending cuts (as the government is rightly committed not to raise taxes but even to trim payroll taxes) requires painstaking consultations and negotiations with individual coalition partners.

today's news that the Italian senator Sergio De Gregorio has left the Prodi coalition can hardly be considered welcome, especially with the vote on the 2007 budget looming:

Political power on Tuesday seeped away from Romano Prodi, Italy's centre-left prime minister, after a senator defected from his ruling coalition, leaving its majority in parliament's upper house hanging by a thread.

The effect of Sergio De Gregorio's departure became instantly clear on Tuesday, when Mr Prodi's coalition lost a full vote on the Senate floor for the first time since it won a narrow general election victory in April.

With the two houses co-equal in powers, the defection means that the government will devote all its efforts to passing the 2007 budget, which is already under attack from the coalition's leftwing elements.

This adds to the pressure on Mr Prodi whose government is already in turmoil over a controversy involving Telecom Italia, the country's biggest telecommunications company, which has exposed the prime minister to criticism from his coalition's two main political parties.

The government will face more difficulties next week when it puts the final touches to the 2007 budget, which contains €15bn (£10bn, $19bn) of deficit-cutting measures that leftwingers in the coalition want to water down.

Italian Consumer Confidence Index

Italian reader Paola wrote in to bring to my attention that consumer confidence just rose in Italy (I had seen this covered by Bloomberg).

Let me first make a linguistic point, the difference between sperare and aspettare. Sperare means to hope, while aspettare to expect (or to wait). I think sometimes we may confuse these two ideas. We try to expect what we hope for (Spanish is even clearer here, since esperar covers the area of meaning occupied by these two verbs in Italian). What I think is that people, and Roberto at Wind Rose Hotel, sometimes finds himself doing this I fear, sometimes mix-up the two. Obviously we all hope for the best for Italy, but hope sometimes is not enough, sometimes we need to apply reason (our rational side), even if emotionally this is hard.

Italian consumers appear to be feeling good. This is welcome news, but as an economist I have to ask myself whether this feelgood effect is sustainable. Looking at the investor confidence indexes in Germany, and the evolution in the housing market in the US, it seems that 2007 is not set to be an easy year.

This is doubly the case for Italy, which will feel the speed reduction in Germany at one and the same time that the Prodi government will be introcdicing a difficult and painful set of spending reductions. In the circumstances my opinion is that the 'feelgood' effect will not last (unfortunately).

To illustrate some of the difficulties we might look at what is happening right now in Hungary. Also of relevance is this comparison made by George Kopits (now on Bank of Hungary monetary policy board) in the WSJ Europe (Thursday -- subs. req'd)) pursuing the Italy-Hungary comparison. Here are the closing paragraphs:


There are, however, differences in the approaches adopted by Budapest and Rome. The new Italian government is composed of a loose coalition of divergent political parties holding only a razor-thin majority. Any initiative to reduce the budget gap through spending cuts (as the government is rightly committed not to raise taxes but even to trim payroll taxes) requires painstaking consultations and negotiations with individual coalition partners. To strengthen his hand, Prime Minister Romano Prodi appointed internationally respected Tommaso Padoa-Schioppa, a former member of the European Central Bank's executive board, as finance minister. Mr. Prodi also named an independent commission headed by a respected civil servant, Riccardo Faini, to shed light on the public sector accounts. In addition, the government quickly passed a supplementary budget to contain this year's deficit and started to deregulate some domestic services. Laudable as they might be, these initiatives are only the beginning of a genuine adjustment effort. It remains to be seen whether the structural reforms the government announced in July will in fact be implemented. The immediate challenge for Rome is to resist calls to water down spending-cut plans for next year, given that revenues are expected to surge due to higher economic growth than previously anticipated.

The re-elected Hungarian government, on the other hand, enjoys a commanding legislative majority. But it needs to overcome an enormous credibility gap, having missed its budget targets by a long stretch five years in a row. Whether the prime minister's leaked confession will boost his credibility or further undermine it remains to be seen. Having contributed significantly to the budget imbalance with a large dosage of creative accounting, the government has yet to persuade financial markets and EU institutions that it will undertake the necessary fiscal reforms. The medium-term budget plan that Budapest submitted two weeks ago to Brussels is frontloaded with a number of apparently improvised measures, mainly tax hikes and one-off spending cuts. And yet, it could provide the starting ground for restoring fiscal sustainability -- if it is beefed up with far-reaching reforms, including an overhaul of generous entitlement schemes.

Clearly, in both countries, the budget programs need to be subject to close outside surveillance. In Hungary, the recently appointed independent "convergence council" should not only issue a candid assessment of the budget program but also play an active role in monitoring its execution. In addition, the European Commission and EU finance ministers should exercise effective peer review of each country's performance. The strict enforcement of the Stability and Growth Pact's fiscal criteria would serve the long-term welfare of these member countries, as well as the interest of the entire EU.

Failure to bring the budgets of these countries under control could have dire consequences. Italy's economy would experience a lengthy period of stagnation, bogged down by a further erosion of its competitiveness. That's because large public deficits tend to crowd out private investments, while distortions from generous welfare payments and high taxes dampen labor force participation and productivity. Prolonged stagnation in Italy would weaken the entire euro zone just when economic growth in the U.S. is about to slow down.

In Hungary, the immediate stakes are far higher. The country could lose EU cohesion funds and its euro accession could be postponed indefinitely. More importantly, Hungary ranks among the countries most vulnerable to a financial crisis if investors decided to pull out en masse. Contagion from a crisis in Hungary to other emerging-market economies (notably Poland and Turkey) would, in turn, be difficult to avoid.

Ultimately, the fiscal drinking habit can be kicked only if the political elites show conviction and manage to garner public support for unpopular measures.

In Italy, fiscal reforms, accompanied by the liberalization of the labor and commodity markets, would help jump-start productivity growth and competitiveness and reduce unemployment. Similarly, in Hungary, strong commitment to fiscal discipline would confer multiple benefits, including entry into the euro zone. Above all, restoring credibility would encourage investment and accelerate real convergence in income levels toward the rest of Europe.