Italy's Economic Blues

Includes: EWI
by: Desmond Lachman

All is far from well in the Italian economy. Despite the fact that the Italian government can presently borrow at rates very similar to that of the US government, the country's public debt situation continues to deteriorate in a major way. This should be a matter of immediate concern not only for the Italian government but also for the rest of the world. For at around US$2 trillion, the Italian government bond market is the third largest in the world. The Italian economy would also appear to be too large an economy for the European Central Bank to save should the markets at some stage again conclude that Italy's public debt is on an unsustainable path.

Leaving aside the country's messy politics, Italy's main economic vulnerability is the combination of an unusually high public debt level and a sclerotic economic growth rate. Since the start of the Eurozone debt crisis in 2010, Italy's public debt to GDP ratio has steadily risen from 120% to around 135% at present. Meanwhile, over the past decade, Italy's GDP growth rate has averaged barely 0.3%. Equally disturbing is the fact that the continued deceleration in its population growth does not bode well for its long run economic growth prospects.

Italy real GDP growth

Clouding Italy's prospects for reversing the disturbing rise in its public debt ratio have been clear indications that the country remains seemingly incapable of generating meaningful nominal GDP increases. According to official data released today, in the second quarter of 2014 the Italian economy again relapsed into economic recession with real GDP declining at an annualized rate of 0.8%. This makes it the 11th out of the past 12 quarters that the Italian economy has registered negative economic growth, which has contributed to the fact that Italy's economy today is still around 8% below its 2008 peak.

Equally troubling is the fact that Italy is now on the very cusp of outright price deflation as reflected in the latest consumer price numbers. These show consumer prices to be only 0.1% above year ago levels. With unemployment unlikely to decline below 12% anytime soon, there is every prospect that Italy will experience outright price deflation in the months ahead as the large gaps in its labor and product markets continue to exert downward pressure on prices and wages.

Perhaps even more disturbing than the renewed relapse of the economy into recession is the Renzi government's apparent running out of steam on the economic reform front. While a bold economic reform agenda to get the economy on a better long-run path was set out early this year, very little has been achieved to date beyond limited tax reductions for lower income earners.

In the context of no increase in nominal income, the Italian government must meaningfully increase the size of its primary budget surplus if the public debt is to be returned to a sustainable path. However, this could prove to be very difficult for two basic reasons. The first is that after many years of painful austerity, Italy has seemingly lost the political willingness to endure further budget cuts. The second is that Italy's own experience with austerity within a euro straitjacket has shown that budget austerity can be counterproductive. For without its own monetary policy to offset budget tightening's impact on the economy, such austerity tends to drive the economy ever deeper into recession with highly detrimental consequences for the country's tax collection.

Considering Italy's lack of room for fiscal policy maneuver and considering its ongoing domestic credit crunch, a necessary condition for the country's quickly returning to economic growth would be an improved external environment that would support its export sector. For that reason, one has to hope that the European Central Bank soon moves toward aggressive quantitative easing that might significantly weaken the euro. However, if past is prologue to the future, one should not hold one's breath for that to happen.