Sunday, January 6, 2013

6/1/2013: Italy's Growth, Reforms & Austerity Conundrum

I've written before about the Italian Dilemma and the debt trap on a number of occasions (see this article for example) and my basic view remains the same - Italian economy needs structural reforms to escape the debt overhang trap and increase productivity in non-exporting firms. That gap, in productivity, between the exporters and non-exporters in the Italian case is vast.

Now, it is great to see BCA Research wading in with the similar concern about Italy's productivity problem and the issue of structural reforms: link here.

A chart from BCA:
Alas, the problem is that Italian economy is saddled with rapidly ageing population and the fact that the extent of it has been somewhat masked by the artificial inflow of lower-skilled migrants during the 2000-2007 years (link here) and underemployment of Italian younger workers.

Italian workplace structures (from hiring to firing) and firm ownership (especially smaller family firms, but also unionised larger or legacy employers) actively obstruct promotion of non-Italians to management and higher professional grades. Non-EU citizens with higher skills and their residency in Italy have been regulated by antiquated laws until August 2012 (see here). These are non-meritocratic (see here and here for examples) systems that cannot be sustained in younger societies, let alone in Italy, where emigration and ageing are forcing the workforce to become older and less productive (see an early study here on effects of migration on Italian labor force comparative to other EU countries).

On underemployment of Italian younger workers, here's a chart from 2012 OECD study:

None of this is new, as this study from James Heckman dating back to 2001 illustrates. And none of it is being addressed in Italy so far through the crisis. Monti Government has tinkered along the edges (see here and here), but failed to tackle the real causes of the long-term (decades long in fact) crisis so far - lack of merit in Italian promotion, hiring and firing structures. Monti has tried, but so far failed to push through more ambitious reforms (link here) and Italy remains trapped in the high debt - low growth scenario.

The issue, of course, is whether austerity (cuts and taxes) is in itself structurally reformist. 

In and by itself - it is not, especially if the balance of taxes v cuts is shaded toward the former rather than the latter. 'Shaded' here depends not so much on some set rule (as the Irish Government, for example, likes to pretend) of 40% v 60% or 50% v 50%, but on the starting point for the reforms and the nature of the reforms, as well as other conditions. 

Italian economy is already weighted heavily by huge taxes and indirect charges. For example, Italy has the sixth highest income tax wedge for single average wage earners with no children, per OECD. It is also suffering from a massive demographic problem that exacerbates taxation policy inefficiencies (younger workers are saddled with higher long term tax bills, while older workers are looking forward to a cushioned retirement). Between 2012 and 2016, the IMF expects Italian Government spending to run above 50% of the country GDP, and there was not a single year since 1988 when the Italian Government spending dropped below 47% of the country income. These figures are 1-2 ppts above the Euro area average, but full 15% above the average for advanced economies ex-G7 and Euro area - in other words, the economies with which Italy competes for global markets in skills and exports.

Thus, IMF assessment of the Italian reforms in July 2012 stated: "The government’s near-term fiscal plans are ambitious and critical for sustainability, but more can be done over the medium term to strengthen the fiscal outlook. To support growth, the composition of adjustment should be rebalanced more towards expenditure cuts and lower taxes". 

In other words, austerity is needed (if only to deflate the burden of debt servicing for the Government debt and provide some breathing room for structural reforms that will require much longer-term approach than currently envisioned). But not austerity-for-the-sake-of-austerity alone. Deficit targets are meaningless, in the case of Italy. Reduction in expenditure targets are necessary, and alongside these, reforms of the labour markets.

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