Monday, January 28, 2008

The Economic Background to Italy's Political Crisis

Italy's economic and political outlook continues to deteriorate. That is the only way we can read the political turmoil which currently affects the country and the steady but relentless trickle of negative economic news which continues to arrive on our desks. In recent days we have had the November retail sales data, which showed that sales dropped 0.3% on a monthly basis in November, reversing 0.4% growth recorded in October.

Then there was the ISAE January consumer confidence index, which showed consumer confidence fell back to the lowest in more than two years in January as accelerating inflation and slowing economic growth fueled consumer pessimism.

Then again Italian industrial production fell for a third consecutive month in November.

With this kind of background it is hardly surprising that the Bank of Italy has slashed its forecast for 2008 gross domestic product, citing a worsening global outlook dominated by the US subprime crisis, weakening consumer demand and rising raw material costs. The Bank cut its 2008 growth projection for Italy to 1.0 per cent from a previous 1.7 per cent.

Jobs Boom?

The only area where the outlook is not rather bleak is the labour market, since jobs are being created, and lots of them:

while unemployment has been steadily - I could say relentlessly - dropping in Italy over the last two or three years:

Yet this is not producing the anticipated upturn in domestic demand, largely for reasons - as explained in this post here - which appear to be to do with the rapid ageing of Italy's workforce and population.

Basically the macroeconomic dynamics of what is happening in Japan at the moment are hard to assess, quite simply beacuse we have never really been here before, and there is not consensus on how to interpret what we are seeing. Italy's working age population - ex migration - has touched its ceiling, and without immigration it will now go steadily down and down. The share of the elderly population in Italy is rising and rising, placing a heavy strain on the social security and health system, yet Italy has a well nown long term growth problem, so the dynamics of how you pay for this additional strain are hard to see at this point.

Everything now depends on raising the productivity of those employed. But Italy's performance in this respect has hardly been stellar in recent years and raising productivity today is pretty much synonymous with raising the human capital component of value added. So if in volume terms the numbers of older but less qualified people working - and working in more and more fragile and less and less well-paid occupations - swamps the number of new highly educated workers in highly productive jobs (we are talking about aggregates here) then the new value created by the society in question won't compensate for the contraction in the workforce. This is particularly true when it comes to raising participation rates in that oft quoted potential labour supply, female workers over 55. Many of the women in question are excellent wives and mothers, but given their often very low level of formal education, and given their lack of real experience of work out of the home, the economic worth in value added terms of their formal labour market participation may be much lower than many expect, and certainly this is where the evidence to date is leading us.

Ageing and Export Dependency

I also feel that the Italian experience is very similar and comparable with what we have been seeing in Japan and Germany, but we have the one important little detail in the Italian case that far from being able to gain GDP growth from exports, Italy runs a goods and services trade deficit, so what should be a boon turns out in fact to be a drag on growth.

In fact if we look at a chart which shows both quarterly export growth and quarterly movements in the trade balance the fact that there is a high degree of interdependence becomes obvious. The point here is not to deduce a direct correlation, but rather to show how sensitive Italian GDP growth is to movements in net exports, and this is a by product of population ageing and its inability to depend on internal demand.

Italy's Public Debt

Of course in the forefront of what happens next is bound to be the issue of public finance, and the government debt. Only this weekend Dominique Strauss-Kahn, the new managing director of the International Monetary Fund, warned that the intensifying credit crunch is so severe that lower interest rates alone will not be enough “to get out of the turmoil we are in" in remarks which are being widely interpreted as advocating an increased use of fiscal policy. But this is precisely where Italy is "twice cursed" since she will feel the impact of the turmoil, but will be unable to make effective use of fiscal policy since she is already so much in debt.

Italy has the highest level of pension spending - as a % of GDP - of any of the original EU15 states.

She also has the highest proportion over over 65s:

and the youngest average exit age from the labour force - a combination which it is very hard to see the logic for.

So behind Prodi's sudden fall, a steady mountain of issues are busy accumulating. Back in July last year the Prodi government reach a very imprudent agreement with Italy's trade unions which effectively overturned an earlier Berlusconi era decsion to raise Italy's retirment rate from the current 57 to 60 with effect from 1st January 2007. The age will now be raised steadily and more slowly. But these low retirement ages are ridiculous when you look at Italian male life expectancy at nearly 77.5 - one of the highest in the EU.

According to Eurostat data Italy has consistently run a fiscal deficit since 1990 (when Eurostat records beign):

and the accumulated government debt has consistently been over 100% of GDP throughout the entire period.

This situation, not surprisingly has regularly attracted the attention of both the EU Commission and the Ratings Agencies. The EU Commission had the following to say on the Italian debt situation in their most recent economic forecast (November 2007):

In 2007, the general government deficit is forecast at 2.3% of GDP. The improvement with respect to the 4.4% of GDP deficit recorded in 2006 reflects buoyant revenue as well as the impact of one-offs, which turns from a negative 1.2% of GDP in 2006 into a positive 0.2% of GDP (taxes on the revaluation of companies' assets and proceeds from the sale of real estate.......The government confirmed the target of a deficit at 2.2% of GDP for 2008, with real GDP growth at 1.5%. Starting from a 1.8% of GDP baseline deficit projection based on unchanged legislation, the draft 2008 budget law adopted on 29 September has a deficit-increasing impact of 0.4 pp. The draft budget law foresees a reshuffling of expenditure as well as additional current expenditure and some tax cuts. The financing of the public sector wage agreement for the period 2006-2007 absorbs almost three quarters of the net additional expenditure.

How Long Can You Fudge the Agencies?

Now I appreciate that this deficit review procedure is fairly technical, but I think at least three things shoul be clear.

1/ That during the relatively good years of 2006 and 2007 no major structural reform has been implemented to address the underlying deficit issues, and a good deal of the burden in reducing the annual deficit has been carried by one off measures and higher than anticipated revenues due to the relatively strong recent economic growth.

2/ That the Prodi government was already in the process of loosening the budget adjustment process for 2008 - by accepting a deficit increasing draft budget - even before the impact of the downturn of finances was contemplated, which means of course that we can expect now the outcome to be worse than projected.

3/ That the need for the Prodi coalition to reach consensus with his "social partners" in govenment made the process of structural reform virtually impossible as can be seen from the size of the public sector wage agreement mentioned by the Commission and the about turn on retirement age, and it is this factor really that made the whole political process such an unstable one.

And meantime the ratings agencies are waiting in the wings. Standard & Poor's have already said that the current budget plan won't do anything to improve their rating outlook for Italian government debt (indeed they could have gone so far as to warn that it might deteriorate it), and they are already predicting that Italy may well fail to meet the agreed objective of bringing its debt below 100 percent of GDP by 2010. As and when this fear is confirmed it will be a case of watch this space, I would say, since if Italy proves incpable of resolving this situation now, what realistic hope will there be later?

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