Italy: Can Reforms Lift Growth Prospects?


Key takeaway – The Italian economy is large, relatively diversified and sturdy. Historically, growth has been driven by external factors (e.g.: the “economic miracle” after World War II) or political efforts (e.g.: competitive devaluations and fiscal spending between the 1970s and the 1990s).

By Alessandro Magnoli Bocchi

Key takeaway – For decades, innovation and international competitiveness lagged most peers. After joining the Euro, the Maastricht deficit-and-debt thresholds constrained public expenditures and – as a result – growth declined below the European Union (EU) average. In 2016, growth is stagnant and prospects are lacklustre: power structures hamper meritocracy and risk taking, the investment climate is challenging, taxes are high. A crisis is looming in the banking system. Unemployment is above pre-crisis levels, and poverty and inequality on the rise. Over the next few years, the economy will be exposed to adverse shocks. Going forward, global growth will remain at best sluggish, inflation low. To avoid two lost decades, Italy should not count on external growth-drivers (it would be equivalent to waiting for Godot) but should instead proactively build internal growth-drivers via structural reforms.

The Italian economy is large, relatively diversified and sturdy. Italy is the [third]( economy in the Eurozone (EZ) and the eighth in the world[1]; it is also the second manufacturer in the EU, and the fifth in the world. Finally, with USD454.6 billion sold abroad in 2015[2], Italy is the eighth global exporter. Agriculture[3] contributes 2.2 percent to total gross domestic product (GDP), industry[4] 23.6 and services 74.2. Private savings are above the EZ average[5].

After World War II, the “***economic miracle*”****[6]** transformed an agricultural society into one of the most industrialized economies in the world. The post-World War II economic expansion[7] enabled the transition from a poor, rural economy to an industrial power, and a trade leader. Between the late 1940s and 1970s, Italy’s growth was lifted by an unprecedented sequence of historical events. First, between 1948 and 1952 the European Recovery Program (the Marshall Plan) provided USD1.5 billion in aid[8]; second, between 1950 and 1953 the Korean War boosted foreign demand for Italy’s industrial goods – mostly metal and manufacturing; and third in 1957, the creation of the European Economic Community (Italy was a founding member) provided investing and export opportunities via a customs union and a common market. The concomitance of abundant cheap labor, ample investments and a rising international demand enabled the development of small and medium-sized enterprises (SMEs) in export-related industries. Between 1950 and 1962, the Italian GDP doubled[9]. From 1951 to 1971, as average per capita income trebled in real terms, consumption soared[10]. At the same time, the establishment of a generous [welfare-state](,%20I_European%20welfare%20states%20explanations%20and%20lessons%20for%20developing%20countries%20(LSERO%29.pdf) brought about higher living standards[11].

Between the 1970s and the 1990s, economic growth stagnated and was revived through political efforts. Over the last three decades of 20th century, a challenging business climate, lack of meritocracy, wage growth in excess of productivity, inflexible labor markets and a chronically low investment in research and development (R&D) and education led to: a) little innovation; b) one of the lowest productivity growth rates among developed markets (DMs) – of both capital and labor; c) declining competitiveness; and d) stagnant salaries and low employment rates. In absence of external growth-drivers, Italy followed – for about thirty years – a simple economic model: “devalue and spend”. First, currency devaluation to maintain international competitiveness; then, massive fiscal spending to support income generation, especially in the south. By the end of the 1980s, unsustainable fiscal deficits drove economic growth. The result was a weak currency and a public debt at 104 percent of GDP in 1992.

Joining the Euro barred competitive devaluations and limited budget deficits, and growth declined below the EU average. In the 1990s, the Maastricht deficit-and-debt thresholds[1]constrained public spending. Inevitably, consumption, investment and employment declined. Between 2000 and 2008, economic activity was hampered – and potential growth was lowered – by the combination of: a) restrictive economic policies (high public debt-to-GDP levels reduced the fiscal space and infrastructure spending); b) limited innovation and an often negative total factor productivity (TFP); c) weak corporate profits and generous labor market benefits; d) excessive bureaucracy; and e) high tax rates. In short, the economy was trapped in a low-growth model. As most reform attempts failed to address these rigidities, the economy became unable to face significant global developments, especially in the fields of trade (i.e.: the rise of emerging markets – EMs) and technology. Over the last two decades, average annual growth rates were flat and below the EU average.

Now growth is stagnant … Since end-2008, the economy was hit by two recessions – after the 2008 global financial crisis and the 2011 European debt crisis[12] (each recession lasted longer than in European peers) – and shrunk by 6.76 percent for seven quarters and by 9 percent up to 2014. Between 2009 and 2012, manufacturing output[13] plunged and almost one-out-of-five manufacturing firms closed down. Over 2011-14, investment remained sluggish, productivity growth stagnant[14], and domestic consumption dropped[15]. As a result, in 2015 nominal GDP was 17 percent below 2009-levels[16], and – despite an improved fiscal deficit (at 2.6 percent of GDP, from 3.0 percent in 2014) – the public debt rose to EUR 2.2trillion (tn), or 132.7 percent of GDP[17] (from 123.3 percent in 2012)[18].

… and prospects are lackluster. The economy is not expected to return to its pre-crisis (2007) real output peak until the mid-2020s. In 2016, companies remain pessimistic about the outlook, especially in manufacturing[19]. Infrastructure, especially in some southern regions, needs major upgrading. Despite several reform attempts, various interest groups – including organized crime – remain involved in the country’s economic life. Over 2016-21, Italy’s economy is expected to grow at around 0.8-1 percent[20], supported by expansionary monetary and fiscal[21] policies. Investment, a necessary enabler of a sustainable recovery[22], can only be financed by firms’ retained earnings[23]. Weak external demand is expected to reduce net exports[24]. Inflation is low and below ECB’s target[25]. The risk of deflation is concrete: in August 2016 consumer prices decreased by 0.1 percent year-on-year (y-o-y) and – driven by low energy prices, anemic credit and weak demand – is in negative territory since February.

The power structure hampers meritocracy and risk taking. Jobs, wealth, and power tend to be distributed by “birth” rather than according to talent and hard work. Most regulations favor élite-capture[26]. Meritocracy – choosing the best for the job – is hardly practiced, especially in the civil service. Nepotism drives away valuable talent trained at considerable cost[27]. Managerial selection is based on loyalty rather than competence. The distribution of welfare-benefits doesn’t lead to social justice: it just keeps the system going. In short, one’s birth determines life-outcome and restrictions on social mobility are [pervasive]( Taking risks doesn’t pay off. Inevitably, risk-aversion leads to little or no innovation.

The investment climate is challenging, taxes high. Global investors consider the business climate relatively favorable[28]. Yet, when compared to its EU peers, Italy attracts littleforeign direct investment (FDI)[29]. According to Italy’s Central Bank, since 2009 the systemic inefficiency of the country’s institutions has deterred FDI for a total of EUR 16.0 billion (bn). Indeed, investment is hampered by: a) bureaucracy[30]: administration processes are slow and procedural costs among the highest in Europe. On average, opening a new business requires 16 different procedures[31] and around USD 5,000 in fees; a bankruptcy process lasts a decade, more than 90 percent of companies are liquidated and creditors get back only about 14 percent of their money; b) stagnant productivity; c) a rigid and costly labor market; d) a slow justice system: on average, to resolve a civil action, courts take 2,000 days – i.e., seven years; e) poor infrastructure; f) weak enforcement of intellectual property rights; g)high taxes: the corporate tax rate is 31.4 percent[32] (down from its 1981-2015 average of 41.60) and the income tax rate can reach [43.0]( rates and allowances) percent; h) corruption; i) and organized crime.

The banking system is troubled, a crisis is looming. The banking sector is overstaffed and weighed down by an excessive number of branches: as of December 2015, 644 banks[33]employed 302,757 professionals across 30,091 branches. Decades of stagnation led to an accumulation of non-performing loans (NPLs) in the balance sheets of most banks. To avoid capital reductions, banks did not write off the NPLs, but restructured them through maturity extensions, weakening their asset quality. As a result, most banks could not extend new credit to the myriad of SMEs[34] that produce 68.0 percent of Italy’s GDP, create employment and drive growth. Between July 2007 and December 2015 credit was constrained[35]: new lending to SMEs fell by almost 20.0 percent and consumer credit declined, hampering banks’ profitability[36] (profit margins are among the lowest in the EU). As credit restrictions depressed growth, a slower economic activity brought about new NPLs. In early-2016, NPLs totalled more than EUR300.0 bn, about 18 percent of all outstanding loans[37]. A banking crisis is brewing[38] and government-intervention looks inevitable.

Unemployment is above pre-crisis levels, poverty and inequality are up. At the end of 2015, unemployment declined to 11.7 percent (from a peak of 13.1 in November 2014), driven by a rise of workers with new permanent contracts[39] and job creation in the 50–64 year age group. Youth unemployment is above 35 percent, and long-term unemployment at about 60 percent of total unemployment. Skilled young Italians are increasingly emigrating abroad, hampering potential growth. The incidence of absolute poverty increased to 6.1 percent of households (1.8 percentage point higher than 2011). Income inequality has also increased and is