Macroeconomic Adjustment in the Euro Area II: Italy

Early warning. This is a monster post. I hope it is worth the ride.

In fact this is the second post in a series I started here (and unfortunately it is also a monster one, so again watch out). Essentially I am taking Chapter 2 of the recent European Economic Advisory Group (EEAG) report on the European Economy 2007 - which is entitled Macroeconomic adjustment in the Euro Area: the Cases of Ireland and Italy - as a starting point for a much more general reflection on how the euro system works, and as a pretext for continuing the search for the structural drivers of the European economies (and here and here). The current post will largely deal with the Italian case, but will attempt to draw out parallels and comparisons. A third post will look at the role of exports in the German economy, while a fourth one will attempt to draw together the threads and examine what may be learnt.

So coming to Italy, as the report notes, GDP growth in Italy has been very sluggish over the last decade or so. As can be seen from the chart below, GDP growth since 2002 has been well below the EU average:



(Please click over all images to get a better view).

This is not, however, a recent phenomenon, since as the next chart shows, Italian GDP growth has been low since the early 1990s:





In fact Francesco Daveri and C. Jona-Lasinio - in a most interesting paper on Italy's relative economic decline entitled Italy's Economic Decine, Getting the Facts Right (of which more below) - say the following:

Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s (so far we are at some 0.6% over 2000-05, if per-capita GDP stays constant in 2005). In any case, nowadays, the miracle years of the1950s-1960s seem quite far away in time.

They also produce this chart which puts Italian long term growth in context:



And the situation becomes even clearer if we look at this chart they produce, where it can be seen that per-capita GDP in Italy has only rosin more quickly than the combined rate of France, Germany, the UK and Spain in six years since 1980, and in none in the last decade (during which time, it should be remembered, German per capita GDP growth has itself been very low).




as Daveri and Jona-Lasinio comment:

"(The chart)...concisely shows that Italy, being much poorer than Europe (poorer than France, Germany and the UK, but richer than Spain) in 1950, has been catching up fast until – roughly - the early 1990s. This process of convergence has reversed its course since then, however. In the 1950s and the 1960s, Italy grew faster than Europe six times in each decade; in the 1970s and the 1980s this occurred four and five times respectively. In the 1990s, instead, this occurred only twice, in 1991 and 1995. Since 1995, then, Italy’s per-capita GDP has grown less than (the other big countries in) Europe’s GDP."

they also add this rather intriguing comment:

"Altogether, the long-run data suggest that the bad performance of the Italian economy is not the figment of the currently unfortunate business cycle contingency. This is why speaking of decline may not be totally unwarranted. With one caveat to add, though: given that the rest of Europe has been and is still growing at a positive pace, Italy’s alleged decline is of a relative, not an absolute type. Italy’s per-capita GDP has simply grown not as fast as Europe’s GDP, but has not diminished over time (yet)"

That "yet" word seems to be looming rather ominously, since with the growing age-related dependency issue just over the horizon, such a decline in the future can certainly NOT be ruled out given current trends. More importantly though, Daveri and Jona-Lasinio seem to give little credence to the idea that Italy's problems can be simply placed at the door of an immediate business cycle conjuncture, or shock (although such shocks may well be exacerbating the problem).

Going back now for a moment to the first chart it is clear that, despite a relatively relaxed monetary stance from the ECB, Italian inflation has been trending down in recent years. This is undoubtedly in part associated with the relatively sluggish rate of growth in internal demand from which Italy has been suffering - and it should also be noted that this drop in inflation has come despite a steady fall in Italian unemployment and a continuing rise in wage costs. The contractual hourly earnings index rose by 3.3% year on year in October, November and December 2006. Over this period the largest annual wage increase was recorded by public-sector workers, whose salaries rose by 5% y-o-y, continuing a longer-running trend. In general - and despite lower productivity rates, government workers have been getting higher pay increases than private workers during the last five years. Wage inflation was at its lowest in the services sector, with a rate of 1.9% y-o-y in October and 1.8% in November and December. In industry (excluding construction), wages rose by an average 3.7% y-o-y over the three months. (Overall hourly earnings rose at 3.3 % in 2004 and 3.0% in 2005).

Of course the recent drop in energy prices does form part of the inflation picture, and it will be interesting to watch what actually happens if energy costs resume their upward trend. It should be noted, however, that despite this downward trend in the rate of price increases, and despite the lackluster growth, the Italian inflation rate has remained stubbornly around, and often slightly above, the euro area average, as can be seen from this chart:


Now turning to the constituents of GDP, we can see from the chart below that, whilst domestic consumption did gain some momentum during 2006, the general picture has been one of very slow growth in domestic private demand (please click over chart to read). In 2004 private consumption grew by only 0.5%, and in 2005 it was absolutely flat (0% growth). This position is now increasingly being mirrored by Italian government consumption which is quite tightly constrained due to the growing deficit problem. Indeed what evidence we have to date from 2007 suggests that the underlying weakness in domestic consumption continues.



Now, as can be seen from the next chart, public consumption in Italy is relatively important, since private consumption only constitutes some 60% of GDP (as opposed to nearly 70% in the USA), so given the relatively weak export performance of the last decade (of which more below), and the weak growth in private consumption, government spending has been playing a significant role in maintaining what growth there has been. This will now have to change if Italy is to bring the deficit (which is currently around 107% of GDP) down.


Returning to the EEAG report, as the authors say:

Our analysis focuses on Italy as an example of slow adjustment in response to shocks reducing foreign demand. The creation of a common European currency coincided with a strong crisis in competitiveness and productivity in Italy, exacerbated by the appreciation of the euro since 2002.

In addition they also note:

The Italian export crisis has not erupted suddenly but has been developing since the mid-1990s. Between 1995 and 2005, the share of Italian exports in world exports at constant prices fell from 4.6 to 2.7 percent, a 40 percent drop. The comparison with Germany...is striking: Over the same period, the German export share grew by 15 percent. If exports shares are instead calculated at current prices, the share of Italian exports in world exports fell from 4.6 to 3.7 percent (see De Nardis and Traù 2005). Of course, Italy is not the only developed country to lose market shares over the period, as there is a trend shift in favour of the emerging market economies.

Well the comparison with Germany is here frankly interesting, since quite simply, in terms of their demographic profile, Germany and Italy have a lot in common, a lot more in common with each other, than either have with say the UK, or France, or Spain, or - indeed - Ireland. Both Germany and Italy have suffered from ongoing weaknesses in their domestic consumption (and neither of them, of course, have recently had housing 'booms', of which more later), and both need to address this structural issue in internal demand - which seems to be related to population ageing - by becoming more competitive in their export sectors. But what differentiates these two economies is that while Germany GDP growth has increasingly come to depend on a very efficient export sector, in Italy shortcomings in exports and domestic consumption have rather been compensated for by increasing public spending and growing government indebtedness.

The accompanying chart makes the relative export evolution clear:



So Germany has done immensely better than Italy in the export sector, and indeed, much better than many others internationally, since Germany's share in global exports started from a relatively high initial level. The comparison shown in this graph is revealing:




It becomes even more revealing when we look at how closely the Italian path mirrors the French one. Yet France has not had anything like the same low growth problems that Italy has had, basically due to the relatively better health of domestic consumption. And the question many might like to be asking themselves at this point is why should this be, why this difference in internal consumption between Italy and France?

And it is here that I find myself parting company somewhat from the general approach of the EEAG report, since they tend to focus on what they take to be a shock-induced external competitiveness problem which they argue may have developed in Italy since 2002, whilst I think it is important to try to situate Italy's recent problems in a much broader historical and evolutionary perspective:

Nonetheless, the Italian competitiveness crisis substantially worsened after 2002, coincident with the appreciation of the euro. It is apparent that the Italian export crisis became acute after 2002. The index of industrial production for the exporting sectors lost approximately 6 points relative to non-exporting sectors from 2003 on. A similar gap can be detected for capacity utilisation. In response to the large external shock to export demand, adjustment would require real depreciation.

Now certainly there is no doubting the fact that the Italian export sector has been suffering from a competitiveness problem, and while there were signs that export growth was once more picking up again at the end of 2005, growth once more turned negative in the 3rd quarter of 2006. An indication of the competitiveness problem can be found in this chart which compares real effective exchange rates (or if you prefer relative movements in unit labour costs):



Indeed the general poor productivity performance achieved in Italy in recent years is highlighted in the chart below (which comes from the OECD 2006 factbook) where Italy can readily be seen to have been the worst performer in the OECD in the years between 2002-2004.



So there seems to be no denying this part of the argument, Italy's productivity performance has been lamentable. Italian economists Francesco Daveri and C. Jona-Lasinio - in a paper entitled Italy's Economic Decine, Getting the Facts Right - examine the Italian productivity 'problem' and come to three conclusions:

We reach three main conclusions. First and foremost, most of Italy’s economic decline stems from decreasing labor productivity (not hours). Second, the standard decomposition of industry productivity trends shows that the bulk (80%) of Italy’s productivity slowdown originates from a generalized within-industry slowdown (or outright declines), mainly in durable and non-durable manufacturing. Diminished inter-industry reallocation from agriculture onto market services contributed the remaining 20% of the slowdown. Third, the labor productivity slowdown was mostly accounted for by a marked deceleration of TFP, which was not the result of an unfortunate cyclical contingency (the current slowdown is worse than in any former downturn in the last twenty years).

So, essentially, there has been a within-industry slowdown (ie TFP has not risen fast enough as industries have not transited to higher value activities) AND there has not been a rapid enough movement into the new market services areas.

In some ways this is very compatible with the story the EEAG highlight in the following chart:



What we can see is that activity has been maintained much more in the non-export than in the export-related sectors, and much of this domestically oriented activity may be in more traditional, low-value-added activity, increasingly staffed, possibly, by newly arrived migrants with low skills and education (see below).

But noting this, and leaving matters there is in many ways to remain on the surface, and not to get to the heart of the matter. As Daveri and Jona-Lasinio so cogently argue, Italy's decline is a much longer term phenomenon, and we need to get through to the underlying structural issues here. In this context we may think that comparing Italy and Ireland is rather like comparing apples and pears, the two economies are fundamentally different structurally, but why are they different?

If instead we compare Germany and Italy - which are from many points of view much more alike - we can see that the fact that Italy has been much slower - for internal political reasons - to bite the bullet of the reform process, means that it has been public spending and not the export sector which has been the growth driver on the margin, but this still leaves us with unsolved issues.

What is it that separates BOTH Germany and Italy from France, and why is it that the former cannot rely on dynamic internal consumption, while the latter can? The answer to this apparent conundrum may come in one word: housing, and in the different ways in which the different eurozone economies responded to one and the same nominal rate of interest in terms of the presence or absence of construction booms.

So what determines whether or not there is a construction boom in any given country? Well strangely enough the answer to this seems to be relatively (indeed perhaps deceptively) simple: median age. I have yet to find a society whose population has a median age which is substantially over 40 which has had a construction boom over the last five years which has been of anything like the magnitude of those which have been seen in those societies with median ages in the 35 to 40 bracket.

And why is this important? Well quite simply, developed economies are becoming more and more services driven, and an important component in this whole shift to services economies has been a growing importance for the construction share in economic activity.

Italy is, of course, like most other OECD economies, making the transition to becoming a services, rather than an industrial society, and the share of services in GDP is growing constantly. In the Italian case the services sector clearly constituted the main driver of growth in gross value added in the third quarter of 2006, despite slowing compared with the first half of the year. Services expanded by 0.3% in July-September compared with the previous quarter, down from quarter-on-quarter growth of 0.9% in the first and second quarters. Financial services and real estate, which had been flat in 2005 showed the sharpest rise, growing by 0.6% in the third quarter compared with the second.

So there is some dynamism in the real estate sector, but has there been a boom? And what exactly has been happening to the housing sector in Italy over recent years?

Well the first thing to note - looking at the comparative graphs below, which show trends in EU house prices - is that from the late 80s to the early 90s Italy had quite a significant housing boom, following which prices flattened out, subsequently remaining either static or even falling slightly until the early years of this century:



The graph below shows the position in even more detail, since it gives annual movements in real house prices for Italy from the mid 90s to date, and here we can see how, while at the end of the 90s prices were actually dropping, they did start to rise in the early years of the century, but they subsequently peaked again, and started and have since started to flatten out again, running at a rate somewhere around the annual shift in Italy's CPI, that is they are more or less flat in real terms.



The above graph has been produced by the Royal Institution of Chartered Surveyors as part of their European Housing Review 2007. In that review they have this to say about the current state of the Italian housing market:



The housing market continues to be fairly flat. Prices in 2006 again rose by around 4% in nominal terms and sales dipped somewhat. Prices, in fact, were flat in most of the major cities and it was in suburban and smaller town localities where the market was strongest. So, the revival seen in the economy does not seem to have filtered through to the housing market as yet. The impetus from it was probably offset by rising interest rates in a country where variable mortgage interest rates predominate. It is expected that the market might slow even further in 2007 with continued pressure from rising interest rates. However, no actual fall in prices is anticipated.

The following comments from the RICS report also seem interesting and relevant:


The mortgage market is fairly recent. Outstanding mortgages were only 18% of GDP in 2005, although this was up from 6% in 1990.10 Outstanding mortgage debt per capita is almost nine times less than in heavily mortgaged Denmark, for instance. Surveys suggest that only around half of purchasers use mortgage facilities, despite the apparent tax benefits of doing so.

At present, Italy has an exceptionally low level of personal borrowing for an affluent society. The overall ratio of longterm household debt to household disposable income was only 41% in 2004, less than in any other of the world’s major economies.

The introduction and growth of mortgage lending interestingly has paralleled similar developments in central and eastern Europe. The Italian experience highlights the fact that a country does not inevitably experience a major house price boom just because a new mortgage market rapidly develops.

This last point, that a country does not necessarily experience a housing boom simply because a new mortgage market rapidly develops seems especially important. The question is why not, what are the sensitivity factors? As I keep stressing willingness to borrow on aggregate, which is in part a function of the overall age structure, does seem to be one of the important indicators.

Of course, as the report also notes, demography not only influences the demand for credit, it also influences the long term demand for housing:

The total population is virtually static, because natural declines are being just offset by immigration. Household numbers are also static at 20.5 million. Overall, population is decreasing in the major cities and increasing in the smaller centres. Moreover, there has been a long-term trend, as elsewhere, for residents to move away from the city centre to the suburbs – although this trend is now associated with a counter inwards movement towards the city centres.

In the absence of increased immigration, the total population is expected to stabilise, and then decrease by around 4%, over the next 15 years. Moreover, the population is ageing. There was a very high birth rate in the 1960s but there has been a subsequent demographic transformation, which gives Italy the lowest birth rate amongst OECD countries. As a result, the population is expected eventually to fall significantly, by 6.6. million between 2020 and 2050; by that latter date the population will be a full 15% less than now.

Life expectancy is also high and rising. The result of these changes is that the country is experiencing one of the greatest demographic shocks of all advanced nations. People over 65 years old currently equal 10 million - about 18% of population - and the number will grow steadily to reach an estimated 16 million by 2040. By 2050, 31% of the population will be 65 or over. Such a transformation is likely to have profound effects on the housing market.

Both the decline in population and increasing share of the elderly in it are also stronger trends in the northern regions than elsewhere. In the absence of significant inter-regional or international migration, significant housing surpluses may begin to arise in Northern Italy a decade from now onwards.

So an ageing and potentially declining population (Italy's natural rate of population growth went negative back in 1992, and population has subsequently only risen due to inward migration) would seem to logically exert an influence on demand for the total housing stock, with the one wild card here really being immigration, to which topic we will now move on.

Now the most recent comprehensive study of migration into Italy to appear online is a paper presented by Giuseppe De Bartolo of the University of Calabria: Immigration in Italy, The Great Emergency. The paper makes a useful read, and this despite the fact that the tone and title of the paper is at times rather alarmist - and despite the fact that he clearly overestimates Italy's relative position in the migrants league when he states that "Italy with an annual migratory total of 300 thousand people is preceded only by the United States, whose total is of about a million people". Numerically speaking this latter statement is clearly false, since with an inward flow of somewhere between 500,000 - 600,000 annually Spain obviously has been receiving more migrants than Italy (as, possibly, has the UK in 2004 and 2005 with so many East Europeans arriving), whilst proportionately certainly Ireland (and probably Greece) have almost certainly had rates of inward migartion which have exceeded the Italian inflow. And this has been the case despite the fact that Italy is ageing much more rapidly than any of these other societies, and thus could arguably be more in need of younger migrants. So the fact that Italy has lagged behind in all of this is not without significance. The question is that even if you need migrants, they may not come, and what we need to look at here is what the actual drivers of migration are.

Well, according to the Italian National Statistics Office (ISTAT), on January 1st 2006 there were 2,670,514 resident foreigners legally in Italy, which constituted an increase of 268,357 (or 11.21%) in relation to the same population in 2005.




Now rather than focusing on the absolute numbers of foreign born population in Italy, what is more interesting for us to focus on here are the flows of migrants into Italy over the last decade or so. As the chart below clearly shows these "official" flows tend to rise and fall in relation to the various "regularisations" which have taken place. It should always be remembered that this data only gives a partial view of the actual rate of flow at any moment in time, since during a "regularisation" immigrants who are already in Italy suddenly "appear" as and when they become legal. This is rather different from the situation in Spain, for example, where immigrants - despite having no legal status in the country - normally register directly with their local town hall since subsequent legalisation often depends on the date of this initial registration. As a result we normally have reasonably reliable data on the migrant presence in Spain. Turning to the chart, we can clearly identify the regularisation peaks:



(Source: Blangiardo G. C. & Molina S. (2006). Immigrazione e presenza straniera. (In Fondazioni Giovanni Agnelli (Ed.) Generazioni, famiglie, migrazioni. Pensandoall’Italia di domani. Torino.)

These correspond to the four major regularisation processes in Italy, as Giuseppe De Bartolo explains:


Between 1990 and 2002 the Italian governments passed four regularisation acts: with the law n. 39 of 1990 (the so-called Martelli's Law) regularised 218 thousands of unauthorised migrants, most of them were Africans and Asiatics. In comparison to the following regularisations, with the Martelli law there was the greatest number of irregulars in comparison to the legal component (120.9 rectified for every 100 regular foreigners - limiting ourselves to the immigrants that originate from the countries of strong migratory pressure). This is to be attributed to the circumstance that the law imposed for the regularisation, which was only to show to have already been in Italy on the date of December 31st 1989. On the occasion of the regularisations favoured by the DL (Decreto Legge - Law Decree) 489/95 (Dini decree) and with the DPCM (Decreto del presidente del Consiglio dei Ministri – President of Council of Ministers decree) of October 16th 1998 the rate of irregularity appeared less because of the greater rigor of the norms. With the first provision (Dini decree) 244 thousand people were regularised, while with the second 217 thousand irregulars were regularised. With the two provisions the citizens of central eastern Europe profited the most because of the increase of the illegal flows coming from Albania and Romania. The law n.189 of 2002 (the so-called Bossi-Fini) can be considered the most important legislative measure in this matter. This law has allowed 647 thousands to be regularised; a number just less than the residence permits emitted altogether (680 thousand) on the occasion of the previous provisions since 1990 (Istat 2005)

The table below also provides a convenient summary of the flows across the years.





In this context it is perhaps worth noting that the most recent data on migration into Italy comes from the national statistical office (ISTAT) in the form of three relevant reports:

Popolazione residente e stranieri residenti nei comuni italiani (April, 2007), and

La popolazione straniera regolarmente presente in Italia (April, 2007), and

Indicatori demografici (March, 2007)

These reports are unfortunately only available in Italian.

What they reveal is that (and as previously noted) on 1st January 2006 there were 2.670.514 foreign nationals legally resident in Italy, and this was an increase over 2005 of 268.357 (+11.2%). The 2006 increase was, however, considerably below the increase experienced between 1st January 2005 and 1st January 2004 (+411.998, or +20.7%) and that of 1st January 2004 over 1st January 2003 (+440.786, or +28.4%).

Thus between 1 January 2006 and 1 January 2003 there was an increase of legally present foreign residents of 72% (or + about 1,120,000 people). This gives a flow roughly 350,000 people a year, and this may give us some idea of the real rate of flow. As a result on 1 January 2006 this population constituted some 4.5% of the total Italian population (which was 58,751,711) a level which was still well below the general "Old EU" average.

Again this increase can perhaps be seen in the chart below:





One of the most significant impacts of this immigration will have been to nudge the Italian median age slightly down (but only slightly) since the median age of the foreign born population is 30.8 while the median age of the is possibly around 43. ISTAT estimates the median age of the whole population (nationals and foreign born) at 42.6 on 1st January 2006.

The impact of all of this on the Italian population pyramid can be seen below (again remember to click if you want to see better).




So the arrival of migrants has had some small impact on the Italian age structure, and in particular in the large 30-40 age group, but again as can be seen from the pyramid cohort size is about to decline rapidly and to exert any notable impact on the ageing process these migrant inflows will need to increase dramatically. Otherwise, as is clear from the pyramid, Italy is likely to suffer a grave shortage of younger workers over the next decade or so, especially given that a significant percentage of the existing migrants are in the 30-40 age group, and a decade from now these will be in the 40 - 50 age group.

However inward migrant flows do not constitute the whole picture here. Italy (just like Germany) is also experiencing a significant outflow of qualified and educated young workers:

since the mid-1990’s the share of college graduates among emigrants from Italy has become larger than that share among residents of Italy. In the late nineties, between 3% and 5% of the new college graduates from Italy was dispersed abroad each year. Some preliminary international comparisons show that the nineties have only worsened a problem of ”brain drain”, that is unique to Italy, while other large economies in the European Union seem to experience a ”brain exchange”.

This state of affairs is a pretty significant one, especially in the light of the fact that Italy's population has not been replacing itself since the early 1990s (ISTAT, latest data, PDF link). Since that time there has only been a continuing population increase as a result of inward migration. But, as this Lavoce article stresses, the balance in human capital terms is hugely negative here. That is to say, the inward-migration that is currently taking place in Italy is extremely important in labour force terms, but this added man- and woman-power can only serve to make the path of the Italian economy a sustainable one if at the same time young educated Italians stay and enter the labour force in much more productive, higher-value activities. This position becomes especially important when we bear in mind the large cohort size reduction Italy is about to experience in the 30-40 age group.

Now, if we turn to the Spanish case, we can see from following chart the rapid increase in the foreign born population in Spain in recent years:



Source, INE, Spanish national statistical office.

Now what we can see is that since 1st January 2000 (and rounding out just a little) the foreign born population resident in Spain has increased from nearly 1 Million, to around 4,150,000 on 1st January 2006. This is a total of 3,150,000 in 6 years, or an average of a little over 500,000 a year.

Now it is important to keep in mind that this increase comes from 2 sources, the migrants themselves, and residents from other parts of the EU who have bought homes in Spain during the construction boom (the greying northern population phenomenon). While it may be important for analytic and compositional reasons to distinguish between these two populations (eg for growth accounting purposes), for our present concerns they are a by-product of one and the same phenomenon: Spain's construction boom (Italy could and should, after all, have been attracting these potential clients for her services).

So the question is, do we here have a measure (or rough proxy) for the differences between having and not having a construction boom at a critical moment in your history. As I estimate above, Italy has been attracting migrants at the rate of around 300,000 a year, while Spain has been attracting something more like 500,000, and it should be noted that the Spanish population is (or rather was) only approximately two thirds of the Italian one, so to have had the "Spanish disease" maybe Italy should have been attracting migrants at a rate of around 650,000 a year, or more than double what she was attracting. Since these two countries are quite comparable culturally (that is, it is in principle no more difficult for an undocumented migrant to arrive in Italy and stay than it is in Spain) the differences in the flows most probably relate to differences in the underlying dynamics (ie the creation of employment) and these differences can also be seen in the relative growth rates of Spain and Italy.

But again, Italy's problem doesn't end here. Having such a strong inflow of migrants has clearly revolutionized the whole Spanish employment situation, and creating work for unskilled migrants at the bottom of the ladder has lead to increasing employment of more qualified Spaniards higher up (and note here the OECD productivity chart above, since these different retention and employment creation profiles for the young and educated are probably one of the features in the Spanish productivity performance, which while not outstanding is certainly much better than Italy's).

One key data point here tells all. In the world there are approximately 3.5 million people who live outside Italy and hold Italian passports. Many of these live in Latin America and are the descendants of earlier Italian immigrants. Yet, what we have noted here in Spain is a constant stream of young people entering from LA using Italian passports (young educated Spanish people are not - other than for external experience reasons - leaving in any significant numbers). Strangely this is not happening in Italy, and the young and educated are not arriving in significant numbers, in fact precisely the opposite is happening, young Italians are leaving, and in growing numbers.

So I conclude with a question: is there yet another inflection point to be looked for here, the one between a level of migrant flows which helps you just keep going (and even produces only horizontal growth in activity terms) and one which accelerates the rate of increase in domestic consumption to such a rhythm that it eases a rapid transition to a services economy (ie vertical growth), and in doing so not only gives employment to the native young and educated but even attracts such people from outside in growing numbers (the Spanish phenomenon)?

What I am saying is that everyone would clearly like to attract educated migrants, but not everyone can. Is the difference a function of your overall growth rate, and is housing here a key factor? That, I think, is the question. To be, or not to be (built).

Draghi Lays It Out To Them

The FT today reports on the latest speech from Mario Draghi, governor of Italy’s central bank, and , as the FT says: "he bluntly told the nation’s politicians to stop interfering in the Italian banking sector".

More importantly he stressed that:

the Prodi government must lower taxes, cut public spending and reform the pension system in order to reduce Italy’s crushingly high public debt.

I entirely agree, but since we have just had a bout of tax increases rather than decreases, it is hard for me to believe that he will be listened to very enthusiastically. Meantime, as I post elsewhere, the eurozone economy seems to be slowing slightly, this is not good news for Italy.

There are other signs that the euro-region expansion may be cooling. Export growth slowed to 0.3 percent in the first quarter after 3.5 percent in the last quarter of 2006. Retail sales in the euro area fell for the first month in three in May and French business confidence declined.

In manufacturing, new orders gained at the slowest pace since November 2005, with the index reading 55.4 after 55.8 in April, today's report said. Output growth slipped to 56.1 from 56.9, the least since February 2006.

Recent Italian Data

This is just a short post to let any reader who happens by know that I am - after a long leave of absence - back. And that I will now be posting again reasonably regularly.

Just two quick pieces of data while I am here. Firstly business confidence registered a drop earlier this month:


Italian business confidence fell in May from a six-month high on concern that gains in the euro and slowing economic growth in the U.S. will hurt exports. The Isae Institute's confidence index fell to 96.2 from a downwardly revised 97.9 in April, the state-funded research center said today in Rome.

And then just today we have news that retail sales have dropped again in May for the third month in a row:

Italian retail sales fell for a third month in May as consumer spending continued to be hampered by rising gasoline prices and tax increases.The pace of the decline slowed in the month with a seasonally adjusted index of retail sales rising to 47.7 from 47.5 in April, according to a survey of 440 retail executives compiled for Bloomberg LP by NTC Economics Ltd. A reading below 50 signals a decrease.

Now one thing which is interesting is that employment in Italy (as in Germany and Japan) seems to be steadily increasing, but consumption remains weak:

``Today's figure is a snapshot of the situation of household spending in Italy; we're seeing modest levels of spending in line with what is perceived to be the level of disposable income,'' said Annamaria Grimaldi, an economist at Banca Intesa SpA in Milan.

So this really does present us with the question: is Italy getting the German/Japanese elderly society disease of low internal consumption and strong export dependence for growth? If so the export sector really does need to be rejuvenated in order to try and push GDP growth rates about critical levels to maintain debt sustainability. Last years 1.9% rise in GDP - good as it was in Italian terms - simply won't do. And growth this year looks decidedly more wobbly.

More, and more in-depth, soon.

Italy's Economic Problems Under The Spotlight

As Manuel points out in his accompanying note, Romano Prodi's resignation as Italy's Prime Minister is a rather sudden and dramatic, but scarcely unexpected, development. The immediate political crisis may be resolved as rapidly as it appeared, but again as Manuel indicates it may only serve as a prelude for further things to come, and the fragility of any government coalition which may be put together only underlines the difficulties Italy will almost certainly have in addressing what are important ongoing economic problems. This brief note will simply attempt to outline some of the main problems, in order to contextualize the political problem a little.

The Deficit

First and foremost among Italy's immediate economic problems is the question of the government deficit. The debt to GDP ratio in Italy - which is currently somewhere in the region of 107% of GDP - is second only to Japan in magnitude, and the short term position has only been deteriorating of late, with estimates for the 2006 deficit being around the 5% GDP level.

All of this has, of course, placed Italy in somewhat bad odor in Brussels, and lead to the opening of an ongoing excess-deficit procedure from EU Economics and Finance Commissioner Joaquin Almunia under the terms of the revised Stability and Growth Pact. The seriousness of the situation hit the headlines last October when the credit rating agency Standard and Poor's downgraded Italy's credit rating from AA to AA-. All of this would come to have an even more ominous dimension if the situation continued and Italy's credit deteriorated further as the ECB has already indicated that should the grade drop below A, then they would cease to accept Italian paper as part of their reserves.

The upshot of all this is that the Prodi government adopted a fairly restrictive budget in fiscal terms for 2007 in an attempt to bring the deficit for this year down to within the 3% limit set by the EU SGP. Now this budget has been extensively criticised for it's shortcomings (and here, and again see the OECD view here), especially for the emphasis it places on tax increases and one-off measures over structural adjustments in expenditure as a way of addressing what are, after all, long term issues (shades of the German VAT hike here, except that in this case it is personal taxation for higher income earners which bears the brunt rather than consumer taxes), nevertheless it is obviously a step in the right direction, and what matters now is the follow-up, and especially the need for a major attempt to put some sort of order into the long run problems with the pensions system which in the context of the rapid ageing of Italian society (and here) is evidently not sustainable as it is.

And it is in this follow-up process that is precisely the issue in the current crisis, since there is no consensus at all on the need for these kind of reforms among the components of the Prodi coalition (which is why I feel the best outcome which could be expected from the crisis is the incorporation of the old Christian Democrats in the coalition, but again as Manuel indicates, it is far from clear that the left can tolerate this).

As Morgan Stanley's Vladimir Pillonca noted in a useful summary of Italy's current economic situation on the GEF back in January, the very good economic performance (at least by Italian standards, around 2.0% y-o-y, which was a significant increase on the lackluster average of 0.6% achieved during the years 2000-2005, but was still well below the eurozone average of 2.7% for 2006 ) attained during 2006 has had a positive impact on the short term debt dynamic. The trouble is that with most forecasts indicating a mild slowdown in global and eurozone growth this year, and lingering doubts persisting about the short term sustainability of momentum in Germany (Italy's chief export market) it is hard to see this dynamic being sustained across 2007, and any faltering of Italian growth will immediately begin put pressure on the underlying fiscal deficit situation and will once more raise the spectre of a further credit downgrade from Standard and Poor's.

Human Capital

Another preoccupying feature of Italy's forward looking situation is the net human capital balance that the country is sustaining. I have written extensively on this topic here (and here). The heart of the problem is that Italy has a substantial outflow of young educated people (as exemplified by the fact that the percentage of university graduates leaving the country in search of a brighter future is now running at some 4% of the total, up from 1% at the start of the 1990s). This situation takes on added importance in the light of the fact that Italy now has relatively few children (a Tfr of around 1.3) and in fact the Italian population stopped reproducing itself back in the early 1990s. To some extent this situation is offset by a large and steady inflow of migrants into Italy (which is to some extent responsible for the continuing buoyancy of the Italian economy) but I think it is important to think here about the human capital implications of what is happening. I think there is a general consensus among those who study the ageing societies problem that public finances are only sustainable in some of the worst affected societies if their economies manage to achieve a substantial move up the value chain into higher-value-added economic activities. Attracting migrants in substantial numbers to carry out low value work may help short term GDP numbers (as well as the government revenue position) and may indeed help correct some of the structural deficiencies in the population pyramid, but this alone will not turn Italy's welfare system and the associated funding issues from a unsustainable to a sustainable one. To achieve this target Italy needs to retain its talented young people, and put them to work in economic activities which are commensurate with their abilities. Hence the need for major reforms in the labour market, in the ease of setting up businesses (reducing red tape) and in the cost structure associated with the initiation of new types of economic activity.

And here again is another difficulty with Prodi's coalition, since one part of the coalition may well resist such changes ferociously.

Growth Weakness

As has been suggested above, Italy's growth problem is not a new one, and has been persisting for many years now. As can be seen from the chart below Italy's performance has substantially lagged behind that of the other main EU economies since the start of the nineties.


Indeed, as Italian economist Francesco Daveri points out in an extremely interesting podcast (Productivity Growth in Europe), Italy's growth rate has been steadily declining at about the rate of 1% a decade since the 1960s. Again this decline in trend growth has been associated with a steady stagnation in the rate of productivity growth, as Daveri outlines in this paper. Such is the downward secular tendency in Italian growth that it has really become impossible to clearly identify what trend growth is now in Italy, and thus it is hard to determine what part of 2006 growth is simply a temporary 'spurt' and what part is a real improvement in the underlying situation. Only 2007 will begin to make this point clearer. However it is obvious that if any real and lasting progress is to be made on this front, then substantial structural reforms are urgent.

Ageing and Saving?

Part of the issue with the immediate outlook for the Italian economy is the question of just what will be the propensity to save of Italian consumers and wage-earners from any forthcoming increase in income stemming from the recent comparatively good times and the apparent tightening in the Italian labour market (a tightening which is, remember, in part produced - as in the German and Japanese - and here - by the ageing process itself, since the larger number of workers to be found in the retiring older generations are not matched by equivalent numbers in the younger ones that replace them, although this tendency is in part offset by raised participation levels from young women in comparison with their older counterparts, but at the same time it is negatively affected by the increasing number of years spent in education before entering the labour market).

Claus Vistesen and I have already been addressing this ongoing weakness in domestic consumption in Germany and Japan, but it is worth pointing out that while the Italian State may be extraordinarily profligate, Italian citizens are not, and have a comparatively high level of personal saving (there is little in the way of a proerty boom to be found in Italy) as this report from McKinsey and Co outlines. So the most likely scenario is one of mid-term continuing weakness in consumption, and the best possibility for growth would seem to come from structural reform and growing export dependence.


The Outlook Going forward

As mentioned above Vladimir Pillonca offers a pretty balanced assessment of the immediate outlook for the Italian economy. Recent data for both consumer confidence and business confidence are certainly better than many (myself included) actually anticipated, and the Italian consumer appears to be remaining surprisingly robust (although we still need to see some real hard data for 2007, and we also need to see how the political crisis impacts on the confidence mood).

Also Italy seems to have begun to wake itself up to the advantages of a Japan/German style export-lead growth model, and there are serious moves afoot from Italian companies to try and leverage the opportunities which India seems to be offering (here, in Italian unfortunately). Confirmation of this tendency is already to be found to some extent in the recent data, which show that industrial orders have been moving up sharply on the back of significant rise in orders from abroad - 13.4% y-o-y in December, following a 6% m-o-m jump in November alone. So whilst there are evident downside risks (such as the impact of the VAT hike on consumption in Germany, the relatively high value of the euro, the fiscal tightening implicit in the 2007 budget, and the interest rate raising policy of the ECB), and while it is still impossible to see at this stage whether or not Italy will have a brush with recession in 2007 (due in part to difficulties in assessing capacity and trend growth movements at this early stage), there are evidently some significant positive elements at work - in particular those coming from corporate restructuring and the growing global export mentality of a core section of Italian higher-value-added industry (with the Fiat group notably taking the lead here), as well as from the growing numbers of migrants now working in Italy, who, as well as being employees remember, will also be customers and taxpayers.

Clearly the rapid rise of a number of the key developing economies (a process which, ironically, is significantly facilitated by the cheap interest rate environment produced by the presence of the "carry trade") offers important opportunities for Italy, Germany and Japan to thrive in the short term on export growth, it only remains to be seen (and to hope) whether or not these possibilities will be thrust asunder in the Italian case by a return of the old enemies of political instability, cynicism and pessimism.