Italy: the frog in cold water edit

April 1, 2006

In 15 years Italy's share of world exports has lost one point, falling from 4 to 3 percent. Since the start of the monetary union, the volume of Italian exports has remained virtually flat, while it increased 25 per cent in Germany, 20 per cent in Spain, 10 in France. This is the result of rapidly deteriorating competitiveness, a serious problem for a country where, like in Germany, exports have traditionally been the main engine of growth. And in 2005 growth, after averaging 1 per cent over the previous four years, has come to a standstill.

-->In a country where the debt-to-gdp ratio is above 100%, when growth stops keeping the debt becomes a challenge. And in 2005, for the first time in 8 years, the debt ratio has increased. In 1998 Italy was admitted into the euro because the risks of a debt crisis were mitigated by a primary budget surplus as high as 6 of gdp: even with no growth and 5% real interest rates, the debt ratio would have remained stable. Today that primary budget surplus has been eaten up: 2 points of gdp by higher current spending, another 3 by lower revenues--in part due to tax cuts--and 1 point from higher public investment. Unfortunately the primary surplus has disappeared precisely when real interest rates worldwide start rising.

Employment has been Italy's only economic success. Between 2000 and 2004, with growth averaging 0.5 per cent per year, official employment gained 1.3 per cent per year, thanks to temporary jobs and to measures which allowed previously illegal immigrants to be legalized. (This by the way is the main reason why the country seemed to fall behind in its level of income per capita). In 2005, however, as the statistical effect from the emergence of previously underground jobs has vanished, employment growth stopped.

Even Italy's attractiveness as a tourist destination is declining: 10 years ago revenues from tourism were higher in Italy then in France and Spain. Today Spain is ahead of France, and Italy comes third with revenues from tourism 37% higher in Spain than in Italy.

The bottom line is that it is hard not to agree with the Economist magazine, which a few months ago, in its cover page, depicted Italy as the "Sick man of Europe".

What lies behind the crisis? Three main factors: rents, a wrong specialization and a public administration that is inefficient but very expensive.

Profits in the manufacturing sector (measured by firms' net operating margin) average 3.5%. In the service and energy sectors they reach 12.5%. Higher productivity is not the explanation. Energy and services are highly protected: their large margins simply reflect correspondingly large rents. In the past five years the wholesale prices of consumer goods increased 5%, but banking services went up 36%, insurance 30%, restaurants, hotels and highway tolls 15%. In some of these sectors Italy is an outlier: in the past 10 years the cost of financial services increased 30% in France, 15% in Germany, 75% in Italy. The cost of fixed line telephone services has fallen everywhere in the world, but (in the past 10 years) by 30% in Germany, 15% in France, 10% in Italy. The rising cost of services keeps consumer price inflation higher than the euro average and, most importantly, keeps nominal wage growing fast as workers bargain for constant real wages. This is one of the main sources of Italy's weakening competitiveness.

The specialization of its exports is hurting Italy. A way to measure whether a country's specialization is the right one consists in computing the correlation between a country's index of comparative advantage in various sectors and the growth rate of world trade in those sectors. In Europe, France and especially the UK stand out, as for both countries the correlation has turned from negative to positive. Spain has also moved from zero to positive, while the correlation for Italy has become large and negative. In textiles, furniture and white goods, for one Armani there are dozens of small firms, especially in the North-East of the country, which can no longer survive the competition from the Far East.

And finally an inefficient public administration. In the World Bank "Doing Business" dataset Italy stands out as the country where opening a business requires the largest number of administrative steps. The 16 steps needed in Italy require 62 working days, while it takes 53 days in France to complete the process, 45 in Germany, and just 3 in Denmark.

Italy needs a shot of competition to speed up the folding up of inefficient firms and facilitate the creation of new enterprises and to eliminate the rents that protected firms extract from the rest of the economy. The labor market is obviously an important part of the problem. 15% of workers are now on part time jobs with no protection and very limited social security benefits. This where all the jobs are created. But 85% of the labor market is still made up of well-protected insiders. When those on temporary jobs will become a sizable fraction of the labor market they will revolt and the insiders will lose. But this will take at least a decade.

Will something be done? I have my doubts. If you visit Italy, you will find no evidence of an economic crisis. The country is rich, probably 25-30 per cent richer than the official statistics reveal. Growth has stopped but if you are rich you can live quite happily without growth, slowly eating into your wealth--especially if family ties are strong and there is always someone around in the extended family who has a job and can help out the kids without one. Berlusconi clearly doesn't help. His line, repeated over and over in the campaign, is that everything is fine, "crisis" is a lie used by the "communists"--meaning anybody who does not agree with him-to scare voters. In a sense he is right: there is no crisis. Italy is like a frog put in cold water. The fire has been turned on and eventually the frog will die. But nicely, almost without realizing.

Mr. Prodi, contrary to Mr. Berlusconi clearly understands all this. But he is a cautious man. His line in the campaign has been: "We are in trouble and I'll do all that is needed to turn Italy around. But only after everybody will be convinced that my reforms are in the best interest of the country. No cold showers." Unfortunately without a few cold showers we will end up like the unfortunate frog.