Against the tide: Italy is a boiling frog
Time is running out for Italy to make the reforms it needs to produce a self-sustaining recovery.
The Italian economy is similar to the proverbial frog in the slowly warming pan of water. The frog knows it is getting hotter, but by the time it wants to react it finds it has already been cooked.
Traditional macro or credit analysis would tell you the gas is turned on, but with the European Central Bank expected to launch a sovereign QE programme this month, the temperature has been lowered, prolonging the process.
Low growth is not a new problem for Italy; the country was struggling well before the financial crisis, recording average annual growth of just 1.2% in 1999-2008. Since then, Italy has contracted. This has left real GDP back at 2000 levels. The population has grown 6.8% over the same period though. Consequently, GDP per capita is back where it was in 1997, 11.1% below its peak.
Italy’s problems have been brought about by a combination of high government debt and the absence of any credible supply-side reform, which being locked into the euro makes all the more imperative. All of this manifests itself most clearly in falling productivity. Italy’s shockingly high unit labour costs have failed to adjust at all over the course of the crisis, in stark contrast to elsewhere in Europe’s periphery, underlining the problems of labour market rigidity.
There is simply no way Italy can raise its trend growth rate without pushing up its productivity levels, an adjustment difficult to accomplish from the current base of falling GDP, high unemployment, borderline deflation and rising debt.
|Traditional macro or credit analysis would tell you the gas is turned on, but the ECB’s expected sovereign QE programme will lower the temperature|
The acknowledgement of these structural failings is clearly visible in Italians’ apathy towards both their political masters and, increasingly, the European project. But whether there is enough dissatisfaction to usher in a new progressive era is doubtful. Self-titled reformist, prime minister Matteo Renzi, has appeared more focused on political strategies to cement his grip on power rather than real steps.
Labour reforms are inching their way through parliament but with little prospect of swift execution. Electoral reform, which would strengthen the government’s hand, enabling more effective pursuit of the structural agenda, looks equally tied up.
Despite a shrinking economy, there have been some positive domestic developments that have allowed Italy to fumble along. There has been a marked improvement in the external balances, specifically the trade account, representing a shift of some 3.8% points of GDP in Italy’s favour. Declines in energy prices should enhance this situation.
However, while energy is one input, the main story is still largely one of domestic demand, which has imploded. And the balance of payments numbers overall still highlight the dependence Italy has on foreign financing, specifically in the bond market – mostly government but also the banking sector.
One stabilising factor has been the ECB. Easier monetary policy has been successful in providing a stay of execution for Italy. Still, pushing out cheap money is one thing, creating an environment where this translates into easier private-sector credit conditions and stronger loan demand is quite another. Although Italian banks largely scraped through the ECB’s asset quality review (AQR) by raising bad loan provisioning and shrinking balance sheets, they remain reluctant lenders.
Total employment is down 5.7% from its pre-crisis peak, while unemployment has risen from sub 6.0% to hit a new high of 13.2% in October. The rigidities of the labour market are clear to see when looking at the demographic mix of the employment data: older workers have clung onto their jobs at the expense of the young, leading to diverging participation rates.
Crowding out younger workers from the labour market – the youth unemployment rate is 43.3% – prevents them developing the skills needed to raise productivity and insulate the economy from ageing. The well-educated instead are leaving the country to take their skills where there is demand. This drain is likely to stunt new business creation and innovation longer-term, a critical problem for Italy, where small businesses make up such a large portion of total employment (80% of the corporate workforce and 70% of firm value added).
Given the sheer scale of the structural reform task, it is difficult to envisage a situation where a self-sustaining domestic recovery can take hold or one where the debt burden will begin to fall. The frog is nearly cooked.