Enough Italy Bashing edit

Oct. 26, 2006

The downgrade of Italy by two credit rating agencies is likely to re-invigorate a theory that has some popularity in the financial markets, namely that Italy could well be the first casualty of an ill-conceived monetary union. The rationale: Italy has suffered from a huge loss of competitiveness, its productivity is at a standstill and its public debt is running out of control. Real life has demonstrated that the country cannot compete with her neighbours on a level playing field, i.e. not without the repeated 'shots in the arm' provided by devaluations. According to this line of reasoning, investors should ultimately impose a higher risk premium and, as debt servicing becomes more costly, their pessimism would turn into a self-fulfilling prophecy: Italians would start dreaming of a 1992-style devaluation as the only way to bail out their flagging economy, at the expense, of course, of their main trading partners. I am afraid that the script of this horror movie is based on flawed macroeconomic analysis and poor use of dubious statistics. On the contrary, I believe Italy is on the mend and likely to attract considerably more foreign capital than it has done in the past.

-->First, three key hard facts do not square with this 'Italy bashing'. Since the inception of EMU, Italian GDP has increased by 1.33% per year versus 1.31% for Germany. I wonder which economy was the sickest. Then, Italy's trade balance was in perfect equilibrium in 2005, the non-oil balance posting a hefty 2.4% GDP surplus. In contrast, Britain's and Spain's trade deficits were, respectively, 5.6% and 7.6% of GDP last year. Last, Italy's harmonised unemployment rate dropped from 11.4% just before EMU started, to 7.4% on the latest reading, only two points above the UK level. This is a much larger decline than in France or Germany and comes second only to Spain. Italy bashers who are at pains to explain how a lame duck could manage to reduce unemployment without fuelling wage inflation, may question the quality of unemployment statistics. However, these measures are based on large sample household surveys and are therefore more reliable and consistent than claimant counts, which are reliant on national unemployment insurance systems. They have nevertheless some idiosyncratic features on which I will comment later.

So why are so many analysts convinced that Italy has been priced out of the game by super-competitive Germany? Because they look at measures of competitiveness such as unit labour costs or export volumes. On these criteria, the Italian situation looks truly desperate. Take for example the relative unit labour costs in the manufacturing sector calculated by the EU Commission. On this measure, Italy's competitive position relative to its euro area partners has lost 23.5% since 1999 while Germany's position has improved by 17.6%. There is worse to come: on the OECD measure of real export market performance, Italy has lost 27 points of market share since 1999, twice as much as France, while Germany has gained 4.1 points. Clearly, something must be wrong: how could an economy suffering enormous losses of competitiveness boast a falling unemployment rate and a balanced trade account?

In my view, both unit labour costs and export volumes are tainted by serious statistical uncertainties. Starting with unit labour costs, the weak link is not the measure of costs, but that of productivity, a notorious headache for statisticians. On data gathered by the US Bureau of Labour Statistics, Italian hourly productivity in manufacturing was the same in 2005 as it was in 1999, while it increased by 27% in Germany and France over the same period. I find it hard to believe that Italian hourly productivity has really stagnated for six years and suspect that a combination of large-scale regularisation of illegal immigrants and tax incentives for employers to hire employees who were working without being recorded in payrolls have distorted productivity data. In short, hundreds thousands workers in Italy have moved from the black to the legal economy, artificially bringing down productivity data and probably flattering unemployment numbers as well: It is likely that black economy workers answered 'No' when asked the question 'Are you working?' in the household survey, and now say 'Yes' if they have been hired legally in the meantime.

In fact, since the output of the underground economy is included in GDP as measured by ISTAT, it is fair to say that both past productivity and past unemployment levels were artificially inflated and that current data are closer to reality. From this angle, the fact that a four-point cut in the unemployment rate did not fuel wage inflation becomes less intriguing: in reality, unemployment has declined less than official measures suggest. Back to productivity, the rate of growth was underestimated because of these changes in the structure of the labour market. In the real world, hourly labour productivity has probably increased in Italy about as fast as in the average of mature economies, as a result of technological progress and capital deepening. The problem is that we do not know exactly at what rate.

Turning to exports, here is the conundrum: standard indicators say that Italy's competitiveness has been seriously eroded and, yet, Italian exports are doing well, compared with its peers. On OECD data, Italy's market share of global trade, measured in current dollars, was 3.7% in 2005, vs. 4.1% in 1999, a 10% decline. The OECD bloc suffered from the same loss - its market share dropping from 74.5% to 66.9% over the same period, in favour of China and oil exporting countries. A more relevant measure of Italy's export performance is to compare its nominal exports with those of the euro area. On this yardstick, the only one that really makes sense in a currency union, Italy actually outperformed its peers: Italian nominal exports have increased by 4% more than the average of EMU country exports since the inception of the monetary union.

Here, I believe that the statistical flaw is in the measure of prices. In reality, for lack of a direct measure, ISTAT is using unit values, i.e. export values divided by quantities. When the euro shot up, in 2002-03, a very counterintuitive fact was that Italian export 'prices' (in fact unit values) increased. In my view, this point, which escaped analysts' attention, reveals the underlying and hidden truth: Italian producers have reacted to globalisation by off-shoring production centres to low-cost countries such as Romania and Tunisia and, more importantly, by upgrading their product mix toward more expensive products, in the fashion sector to take a well-known example. Here again, the problem is that there is convincing indirect evidence, such as the export performance, that corporate Italy has changed for the better, but direct and reliable statistics.

Don't get me wrong. I'm not saying that Italy is the new corporate Eldorado or the next stellar macro performer in Europe. The public debt inherited from the past is a permanent Damocles' sword. Labour laws, especially redundancy rules, are rigid, corporate governance is weak, the internal market is inefficient, especially for services, the commercial property market is opaque and in the hands of a small group of investors, bureaucrats and their love affair with 'documenti' are not particularly business-friendly, the population is ageing, pension reform is still 'a work in progress' and healthcare reform is still in limbo. And yet, at the margins, Italy might be the place where change is taking place at the greatest speed. In this regard, Mr. Prodi's strategy is the right one, I believe: commitment to budget consolidation, reduction in non-wage labour costs in order to boost employment and reduce further structural unemployment, and supply-side reforms such as the liberalisation of services. In fact, I would have a wager that the credit rating agencies may sooner rather than later have to re-evaluate the Italian case in a more positive light given faster potential growth and lower budget deficits. Investors should not wait until then.