The sovereign debt crisis in Greece is still in its infancy and its effect on other vulnerable countries, including Spain, Portugal, and Ireland, has been widely discussed. But how is Italy—whose economy and public debt are more than six times larger than Greece’s—faring?
Italy did a better job than Greece of managing its fiscal affairs during the crisis, but its debt as a percentage of GDP is still higher than that of Greece and, since adopting the euro, its competitiveness has deteriorated just as sharply. The combination of high debt, declining competitiveness, and anemic growth means that, even if contagion from Greece is controlled, the Italian economy will remain exceptionally vulnerable to adverse shocks in a highly uncertain post-crisis global environment.
To maintain its membership in the Euro area and avoid its own disastrous sovereign debt crisis, Italy should, as a first step, adopt a three-year program to raise its primary balance by at least 4 percent of GDP and engineer a real devaluation vis-à-vis Germany of at least 6 percent through wage cuts and far-reaching structural reforms. Compared to the programs enacted or planned in Greece, Ireland, and the Baltic countries whose crises have already erupted, these steps are modest and should be interpreted as preemptive.
However, action in Italy and other vulnerable countries will not be enough: the Euro area must ease the painful adjustment by maintaining expansionary policy and targeting a weaker euro. To ensure that the global recovery continues, the G20 also has a vital interest in accommodating the lower euro.
The Post-Euro Boom and the Crisis Bust
After Italy and Greece adopted the euro in 1999 and 2001, respectively, interest rates in both countries fell to near German levels (the lowest in the Euro area), fueling consumer spending and house prices, particularly in Greece. Though the two governments used the lower borrowing costs to increase spending, they were also able to reduce deficits and debt. In Italy, debt fell by 10 percent of GDP from 1999 to 2007. Greece cut its debt by a larger 12 percent of GDP over the same period. This was a step forward, though other highly indebted countries, such as Belgium, did much better.
Since the outbreak of the crisis, debt in Greece and Italy has surged, as in other countries. In 2008 and 2009, Greece ran public deficits twice the size of Italy’s and added about twice as much debt as a share of GDP. But the fact remains that Italy’s debt load today is similar to that of Greece.
Debt as % of GDP, Current and Projected
|Sources: European Commission, IMF, OECD.|
With a public debt of 115 percent of GDP and interest rates near 4 percent, Italy must spend about 4.5 percent of GDP a year just on interest—the equivalent of its public education budget this year. Moreover, even if public revenues are able to cover all expenditures, interest costs will still lead Italy’s debt to grow faster than its sluggish economy—which consensus expects to grow at an average annual rate of 3 percent in nominal terms over the next seven years. Therefore, the debt burden will grow larger each year unless the primary balance (the difference between public sector revenues and expenditures, excluding interest paid on the public debt) moves firmly into surplus. Since Italy’s debt is of relatively short maturity, Italy is potentially more vulnerable than other countries to a change in market sentiment.
Better Fiscal Management
By moderating expenditures, partly via pension reform in the 1990s, and increasing revenue through temporary tax measures, Italy has avoided a starker debt explosion so far. More recently, its conservatively managed banks did not need a bail out, nor did Italy enact substantial fiscal stimulus.
Crucially, Italy’s lower fiscal deficits, together with higher private sector savings, establish an external balance that is also sounder than that of Greece. From 1993 to 1999, Italy’s current account was in surplus, and the country has maintained a modest average current account deficit of 1.6 percent of GDP since 2000. Greece, where domestic demand grew much faster, saw average current account deficits of 9.1 percent from 2000 to 2009. Had growth in Italy led to a domestic demand surge similar to that in Greece, Italy’s current account deficit might have been of similar magnitude. For similar reasons, and because it didn’t attract as much foreign investment during the boom, Italy is also in a relatively healthy net foreign indebtedness position.
Markets have rewarded Italy for its better fiscal management. During the crisis, spreads on 10 year government bond yields rose much more in Greece than in Italy and the difference has grown even starker recently.
Lost Competitiveness and Low Growth Potential
Nonetheless, Italy has lost as much competitiveness as Greece since joining the Euro area. Italy’s unit cost of labor rose 32 percent from 2000 to 2009, comparable to Greece’s 34 percent rise over the same period. To keep its unit labor costs level with those of Germany—where wages essentially kept pace with productivity—Italy should have kept its wages nearly flat in nominal terms over the last decade. Italy’s competitiveness deteriorated even more against other large trading nations, including the United States, China, and Japan—all simultaneously large markets for and in competition with Italian exports.
Econometric studies conclude that falling total factor productivity is responsible for Italy’s low growth problem. From 1996 to 2004, total factor productivity in Italy declined at an average annual rate of almost 1 percent, while it grew by approximately 1 percent per year in Germany. Numerous structural issues have plagued Italy’s economy for decades. These include labor market rigidities and dual labor markets, small average business size, defective and excessive regulations, inadequate public services, insufficient competition in backbone services (including energy, telecommunications, and transport), and profound governance issues in the South.
The consequences of Italy’s lost competitiveness are massive: a recent European Commission study concludes that, from 1998 to 2008, exports of goods and services grew more slowly in Italy than in any other member country, Italy lost the most market share in its traditional geographic markets, and its market share fell by more than can be explained by cost considerations alone. Given Italy’s specialization in low-skill goods, its inability to resort to currency devaluation is particularly challenging.
Hostage to Fortune
Italy’s cycle of high debt and low growth has re-enforced itself for decades, but the uncertainty of the post-crisis world economy poses new risks. In the short term, continued failure by the Euro area to deal with the Greek crisis and contain its spread could easily lead interest premia to surge on both government and private borrowing, eventually stifling European demand. This would kill Italy’s fragile recovery by forcing greater fiscal adjustment and further depressing exports.
On the other hand, sustained global growth would come with higher interest rates and could mean another large oil shock this year or next. This would hit Italy—a heavily oil-reliant country that imports 93 percent of its supply and is limited in its ability to increase exports in order to pay more—particularly hard.
The most pernicious risk is that Italy will continue to lose competitiveness against Germany and other trading partners as the wage and productivity differentials continue to widen. Unchecked, this process will eventually strangle the economy’s ability to grow at all. Financial markets will react (or may anticipate the trend), forcing a Greek-sized surge in the cost of borrowing.
Policy Actions: A Three Year Plan
Italy should not wait for the heart attack before addressing its high blood pressure and excess weight.
- Over the next three years, it needs to increase its primary balance by 4 percent of GDP to ensure that its debt/GDP ratio begins to gradually decline again. By way of comparison, the primary balance improvement expected of Greece under its EU agreement is 10 percent of GDP over the same period.
- Italy must cut its unit labor costs and enact critical structural reforms in order to regain its lost competitiveness. A six percent claw back would regain only about a quarter of the competitiveness lost to Germany over the last ten years, but it would send an important signal to markets. This could be achieved immediately through a six percent across-the-board wage cut, beginning, as in other countries, with public sector workers. Alternately—and politically more likely—Italy could reduce wages more gradually, cutting them 1 percent per year over three years while also enacting structural reforms to raise productivity.
- Critical structural reforms would include removing rules that create a dual labor market and increasing the efficiency of backbone services, which affect the competitiveness of all firms in the economy.
Growth in the Euro area would also help the adjustment—not only in Italy, but also in Greece and other vulnerable countries.
- To ensure growth, Germany and other surplus countries should commit to stimulating domestic demand and relying less on exports to the Euro area.
- In addition, the European Central Bank [ECB] must maintain an expansionary monetary policy that errs on the side of growth for many years. Slightly higher rates of inflation are not likely to increase nominal interest rates immediately, and they will ease the necessary cuts in real wages.
- To help stimulate Europe’s competitiveness during this crucial time, the ECB’s explicit objective must be a weak euro, and the G20 must accept the lower euro if it hopes to avoid implosion of the Euro area. A sequence of sovereign debt crises in Europe would inevitably spill over onto some vulnerable emerging markets and could affect borrowing costs for governments in Japan and the United States, as well as hinder exports there and in China.
Europe’s potential debt crises pose a large risk to a sustained global recovery; these policy changes are the premiums the world needs to pay to insure against another collapse.
Disclosure: No positions