Is the Italian economy really better than it looks?
In today's Financial Times, Daniel Gros has an interesting Oped article in which he argues that the doom and gloom about the Italian economy is overdone. Since I was one of the commentators who about one year ago speculated about Italy's long-term future in the euro area, I would like to address some of the points he raised, which deserve to be taken seriously.
For a detailed summary of his argument, see our morning news briefing on February 7. Basically, he argues that the Italy-bashers rest their case on three arguments: Italy's parlous public finances, its loss of competitiveness, and failure to reform. He then goes on to debunk each one of them. On public finances, he remarks that Italy runs a similar deficit than France and Germany, and financing its public debt at close to 110% of GDP is neither difficult nor particularly expensive. On competitiveness he makes the point that the productivity indicators are misleading, resulting in a vastly distorted measure of unit labour costs. Third, he says, Italy is better at product market reforms than either France and Germany.
Let me address each of his arguments in turn. His calculations critically rest on the assumption of a low spread between Italian and other euro area bonds. That assumption depends again on the credit rating of Italian bonds, market perceptions of a likelihood of future default, and market perceptions about intra-EMU bailouts. While Italy's credit rating has worsened, it is still good enough. Markets currently regard Italy as safe a credit risk as Germany, and they believe that if push comes to shove, EMU governments will bail out each other. If those three conditions persist, Italy's public finances present no problem. But they might not persist.
I partially agree with him on competitiveness. Given strong employment growth, Italy's productivity figures may well underestimate the economy's underlying competitive strength. Market shares of Italian companies have not suffered much, which one would have expected if Italy had experienced a 30% loss in competitiveness against Germany, as the unit labour cost data would suggest. Italian inflation is presently coming down close to close euro area average levels, and pay settlements in the private sector, which is what matters for export competitiveness, are also in line with the European average. So when you state Italy's problems purely in terms of competitiveness, I would agree that the situation is not as bad as it appears.
But Italy still has a huge productivity growth problem, which needs to be urgently addressed. This problem is particularly strong in the public sector, where pay settlements have risen by twice as much than private sector pay settlements in the last five years, and where productivity is abysmally poor by European standards. (see also Tito Boeri and Giuseppe Pisauro's contribution on this issue on lavoce.info).
I totally disagree with him on the issue of reforms. Surely, it is always possible to define a set of reforms, in which one country is doing better than another . Italy, for example, has made more progress than Germany on privatising public-sector banks, though the Italian banking system as a whole remains woefully inadequate and inefficient. While some of the Prodi government's reforms have been eye-catching, such as the deregulation of notaries and pharmacists, and more recently, the ending of monopolies for petrol stations, I doubt that they are the kind of reforms Italy currently needs the most. (see also my blog entry on this subject). The reforms Italy needs are pay and job cuts in the public sector, measures to increase public sector productivity, the implementations of a controversial law to raise the pension age and to unbundle part of the country's corporatist system. Or to put it another way, if Italy had been a better reformer than Germany and France, how come that Italy's productivity performance has been so consistently worse? Surely, this is not just a measurement issue.
I would agree with Gros that some of the Italy-bashing may have been overdone. He is right to cast doubt on some of the simplistic arguments that have been made against Italy. While he acknowledges that Italy still face formidable challenges, I fear he understates the degree of these challenges. I myself do not believe that Italy is likely to leave the euro area, but I would still attach a small positive but non-trivial probability to this event (in other words: a probability of significantly less than 50% but but a little more 0%). If the Prodi government is the most reformist administration Italy is likely to get, as my Italian friends are telling me, then I find it difficult to become optimistic about Italy's prospects.
