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; it is also the second manufacturer in the EU, and the fifth in the world. Finally, with USD454.6 billion sold abroad in 2015, Italy is the eighth global exporter. Agriculture contributes 2.2 percent to total gross domestic product (GDP), industry 23.6 and services 74.2. Private savings are above the EZ average.
After World War II, the “***economic miracle*”** transformed an agricultural society into one of the most industrialized economies in the world. The post-World War II economic expansion 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; 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. From 1951 to 1971, as average per capita income trebled in real terms, consumption soared. At the same time, the establishment of a generous welfare-state brought about higher living standards.
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 thresholdsconstrained 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 (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 plunged and almost one-out-of-five manufacturing firms closed down. Over 2011-14, investment remained sluggish, productivity growth stagnant, and domestic consumption dropped. As a result, in 2015 nominal GDP was 17 percent below 2009-levels, 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 (from 123.3 percent in 2012).
… 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. 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, supported by expansionary monetary and fiscal policies. Investment, a necessary enabler of a sustainable recovery, can only be financed by firms’ retained earnings. Weak external demand is expected to reduce net exports. Inflation is low and below ECB’s target. 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. Meritocracy – choosing the best for the job – is hardly practiced, especially in the civil service. Nepotism drives away valuable talent trained at considerable cost. 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. Yet, when compared to its EU peers, Italy attracts littleforeign direct investment (FDI). 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: administration processes are slow and procedural costs among the highest in Europe. On average, opening a new business requires 16 different procedures 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 (down from its 1981-2015 average of 41.60) and the income tax rate can reach 43.0 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 banksemployed 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 that produce 68.0 percent of Italy’s GDP, create employment and drive growth. Between July 2007 and December 2015 credit was constrained: new lending to SMEs fell by almost 20.0 percent and consumer credit declined, hampering banks’ profitability (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. A banking crisis is brewing 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 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 above the OECD average.
Over the next few years, Italy will be exposed to adverse shocks. Stagnating growth and structural legacies – such as low productivity, high public debt, and bank balance-sheet-weakness –will make the economy vulnerable to: a) volatility in global financial markets and a sudden increase of sovereign bond yields; b) an export slowdown due to a deceleration of world trade and currency wars; c) the rise of populism, spurred by anti-establishment feelings, protest vote, and xenophobia – fed in turn by the migrant crisis and security threats; d) a banking crisis triggered by banks with assets of poor quality and low profitability even under favorable assumptions; and e) cumbersome policy-making resulting in chronic delays of structural reforms. If downside risks were to materialize, consumer and business sentiment would be undermined, investment reduced further, growth stagnate for longer – while Italy’s systemic weight could create significant spillovers at the European and global levels.
Going forward, Italy should not bet on external growth-drivers. Over the next five years, mega-trends will not support an acceleration of global growth. Consumption, investment and productivity will remain sluggish, inflation low. Macro fundamentals are weak: high debt and unemployment will constrain performance. DMs will stagnate and EMs will struggle. Flat real incomes and rising inequality are major political risks. Across the globe, instability, populism and authoritarianism will rise. Political tensions, financial instability, lower oil prices, deflation and competitive devaluations are major economic risks. Fiscal and monetary policy will not support demand and investment. The over-reliance on central banks (CBs) will continue, leading to further financial repression. Liquidity-driven markets will fuel asset inflation and remain jittery. Inevitably, the rising disconnect between fundamentals and valuations will bring about a bear market, if not a crash.
Reforms need to spur internal growth-drivers. To enhance the competitiveness of its economy, Italy needs to enact comprehensive structural reforms. Notably, it needs to: a)promote growth with counter-cyclical fiscal policies – while preserving macro stability – and by further diversifying the economy; b) reform a paralyzed legislative system; c)address rent seeking and élite capture and improve the efficiency of the public administration; d) increase spending in infrastructure and education and bet on public-private-partnerships (PPP); e) reduce taxes, especially on labor, to encourage job creation; f) stimulate productivity growth by removing protective barriers to entry, especially in the service sector; g) align wages with productivity and make the formal labor market more flexible, perhaps by adopting “flexicurity”, i.e.: the ability to balance the “flexibility” needed to adapt to economic changes with “security”, in order to maintain labor protection; h) reform the judicial system and simplify settlement procedures; and i)promote the restructuring of the banking system, in order to improve its strength and reform NPLs insolvency procedures.
 Main exports are: engineering products; electrical equipment; vehicles, aircraft and vessels; base metals and steel; textiles, clothing and footwear; chemicals; food and beverages; precious metals; optical and medical apparatus; stone, cement and glass products; paper.
 The industrial sector enjoys a global comparative advantage, especially in the machinery and equipment subsectors. The automobile, naval, industrial, appliance and fashion design is also a point of strength.
 Households own net financial assets of more than EUR 3 trillion, one-third of which is held in the form of deposits. Furthermore, household debt (in 2014 at 62 percent of gross disposable income) is below EZ average (95 percent).
 On July 1, 1963, at the dinner in Rome’s Quirinal Palace, US president John F. Kennedy said: “The growth of your nation’s economy, industry, and living standards in the postwar years has truly been phenomenal. A nation once literally in ruins, beset by heavy unemployment and inflation, has expanded its output and assets, stabilized its costs and currency, and created new jobs and new industries at a rate unmatched in the Western world.”
 Between 1945 and the early-1970s, Western European countries experienced high, sustained growth and full employment. In West Germany, during the Wirtschaftswunder (Economic Miracle), gross national product (GDP) grew at about 9 percent per year and industrial production doubled from 1950 to 1957. Between 1947 and 1973, during the Trente Glorieuses (The Glorious Thirty), France experienced 5 percent growth per year on average, and the real purchasing power of the average French worker’s salary went up by 170 percent between 1950 and 1975, while over-all private consumption increased by 174 percent in the period 1950-74 . In the 1950s and early 1960s, during the Italian economic miracle, growth hit record high rates: 6.4 percent in 1959, 5.8 in 1960, 6.8 in 1961, and 6.1 in 1962.
 Household ownership of refrigerators and washing machines rose from – respectively – 3 and 1 percent of total households in 1955 to 94 and 76 percent in 1975. By 1975, 66 percent of total households owned a car. Between 1955 and 1971, about 9 million people migratedacross regions, creating large metropolitan areas.
 In November 2011, during the Italian debt crisis (the 10-year bonds yield rose to 6.74 percent; 7 percent is the level where Italy is thought to lose market access) Prime Minister Silvio Berlusconi was forced to resign. An economist, Mario Monti, who had served as a European Commissioner from 1995 to 2004, was appointed Prime Minister of Italy, and lead a government of technocrats, composed entirely of unelected professionals.
 In the first recession, between 2008 and 2009, manufacturing output – under pressure by competition from abroad and the downturn at home – fell by 24 percent. In the second, between 2011 and 2014, output fell by about 10 percent. Only producers of luxury products saw their sales rise, supported by demand from the emerging markets (EM)’ rising middle class.
 In 2015, Italy’s nominal GDP was USD1.8tn, the lowest level since financial crisis, 17.0 percent lower than the nominal GDP in 2009, 8.7 percent higher than pre-crisis (1998-2008) average of USD1.7tn and 20.2 percent lower than the post crisis peak of USD2.3tn in 2011. In 2015, real GDP was 8.5 percent below its pre-crisis peak. While the 2015 Expo in Milan attracted about 20mn visitors from across the globe, in Q4 2015, quarterly growth was 0.1percent – lower than the EZ average (0.3). In December 2015, industrial output fell by a seasonally-adjusted 0.7 percent month on month (m-o-m).
 The investor base is relatively stable and mostly domestic: 66.3 percent of Italian government bonds are owned by domestic investors, up from 56.7 percent in 2010, and Italian banks own about half of this amount (30.2 percent).
 In April 2016, according to trading economics, Italy Manufacturing PMI came in at 53.9, higher than 53.5 in the previous month and above market expectations of 52.9. Manufacturing PMI in Italy averaged 51.9 from 2012 until 2016, reaching an all-time high of 55.6 in December of 2015 and a record low of 48.0 in June of 2013.
 In 2015, after three years of recession, the economy expanded by 0.8 percent, buoyed by accommodative monetary policy, declining commodity prices, and improved confidence. Private consumption and inventory re-stocking were key contributors, while external demand weighed on growth. According to the IMF, over 2019–21, back loaded fiscal consolidation would result in a decline in real GDP growth to around 0.8 percent, including a dividend on structural reforms of about 0.3 percent per year. Absent reforms, potential growth would decline to 0.5 percent, reflecting crisis legacies such as the collapse in investment as well as unfavorable demographics and slow productivity growth that predates the crisis.
 The measures contained in the 2016 budget are estimated to boost growth by about 0.3 percent in 2016 and 2017. After the 2008 crisis, the government tightened the fiscal stance, and in 2013 the structural primary surplus peaked at 4.1 percent of GDP, among the highest in the EZ. Since 2013, fiscal policy was progressively eased, and in 2016 the structural primary surplus is projected to decline to 2.6 percent of GDP, the overall deficit is projected to decline to 2.4 percent of GDP (from 2.9 percent of GDP in 2012–13); interest savings (a windfall of more than 1 percent of GDP) will be absorbed by fiscal relaxation rather than debt reduction. In recent years, the government reduced revenues by easing the tax burden, via, for example: a) the elimination of an effective but unpopular real estate tax on primary residences (home ownership rates are high); b) cuts in social contributions for new hires; and c) a monthly bonus of €80 for workers with incomes below €24,000. Additional revenues were sought through, for example, a voluntary disclosure scheme and gaming revenues. Spending was contained through cuts in capital outlays and the wage bill, through attrition of the workforce and a wage freeze. Yet, social benefits – including pensions – continued to rise and remain an outlier in the euro area. Full implementation of past pension reforms would ensure long-term sustainability.
 The recovery in investment is likely to be very slow. Although in recent months transportation-related investment rebounded and there are tentative signs of stabilization in the construction sector, the investment ratio remains far below that of key EZ partners, following the sharp decline in 2010–14.
 As slowing global demand weighs on exports while imports recover, net exports risk becoming a drag on growth. Real exports are back to their pre-crisis (Q1-2008) peak, but this is a relatively modest performance compared to large euro area partners that are 15–25 percent above pre-crisis peaks. The current account and trade balances remain in surplus, including from favorable commodity prices and more generally import compression in recent years. The current account has been rising from an average deficit of 1.25 percent of GDP in the 2000s, into balance in 2013 and, by 2015, into a surplus of 2.2 percent of GDP, driven by a decline in investment as both the corporate and the public sector deleveraged and a growing trade surplus, helped by lower commodity prices.
 Headline is in negative territory since February owing in part to the decline in oil prices but also subdued demand (as seen in low core inflation). Long-term inflation expectations are still significantly below the ECB’s objective.
 Élite-capture occurs when local economic or political élites use their influence to capture resources (e.g. government programs aimed at distributing funds to the general public) originally destined to the larger citizenry. Some élite-self-perpetuation is unavoidable, but too often family connections matter more than individual abilities. Inherited power and wealth give access to expensive education and valuable contacts, and are powerful predictors of future success.
 The brain drain leads to the cost of a “reverse technology transfer”. Innovations produced by brain drain, owned by the countries in which they are made, will have to be bought by the countries of origin.
 In the 2015 World Economic Forum (WEF) Global Competitiveness Rankings, Italy is ranked 43rd out of 140 countries; in the 2016 World Bank Ease of Doing Business Italy is ranked 45thout of 189 countries. The 2015 UNCTAD World Investment Report ranks Italy 10th. Yet, in the Index of Economic Freedom 2015, the country ranked only 80th in the world, due to the slow legal system, excessive taxation, and a protective labor law.
 The example of the Verona-based Giovanni Rana is paradigmatic. The company produces fresh pasta and after growing at 20.0 percent a year with most of its sales abroad, reached a deal in the US with Walmart. According to the New York Times, in 2011 the company opened a new plant in Illinois, US in just seven months (while expanding the original factory in Verona took seven years).
 For 2017, the government has pledged to implement corporate income tax cuts (to 24.0 percent) and to deactivate a safeguard clause – which it intends to fund with spending cuts – that in times of revenue shortfalls triggers an increase in the value-added tax of up to 0.9 percent of GDP. Despite these measures, the tax burden remains high and keeps constraining growth.
 Since 2015, the government has introduced measures to help banks repair their balance sheets. These range from new bankruptcy laws and the reform of mutual banks, to a securitization scheme for credit disposal and the sponsorship of two private funds aimed at buying NPLs and supporting the recapitalization of weaker institutions.
 The total gross NPL ratio declined to 17.8 percent in Q1 2016 (from 18.2 percent in Q3 2015). NPLs are concentrated in the construction (22 percent), manufacturing (18) and trade (14) sectors and in the corporate space: corporate NPLs amount to about EUR240.0bn, approximately 80 percent of total NPLs and 30.0 percent of total corporate loans. Credit to the corporate sector has continued to decline and in 2016 is about 11 percent lower than in 2011. Provisions amount to 45 percent (excluding collateral and guarantees, as court times to access them are very long).
 Italy continues to benefit from the significant improvement in funding conditions since the end of 2012, but it is still exposed to interest rate hikes and changes in market sentiment. In 2015, interest costs on public debt declined to 4.3 percent of GDP (from a peak of 5.2 in 2012). Yields at issuance on ten-year government bonds fell by approximately 580 basis points between the peak in November 2011 and, despite a moderate increase in mid- 2015 due to spillovers from Greece, continue to decline. This is partly due to ECB bond purchases and other forms of liquidity support, resulting in low bond yields and greater debt servicing flexibility. The average maturity of government debt is 6.5 years, and this has helped to shelter the country from interest rate shocks. The annual refinancing needs (between EUR 380 and EUR 385 billion, including the rollover of 6-month BOTs – approximately 23.5 percent of GDP), cost about EUR 70 billion in interest.
 “Market correction”: a fall of more than 10 percent from the 52-week high, over a single week. “Bear market”: a fall of more than 20 percent from the 52-week high, over 300 days. “Market crash”: a fall of more than 10 percent in just one day, or 40 percent from the 52-week high over 150 days.
 The Asian experience has shown the importance of sound economic management for job creation. Economic stability matters for employment, and maintaining it during a crisis requires strong institutional fundamentals as well as flexible macro-economic policies. When the 2008 crisis hit the Asian region, solid domestic fundamentals combined with a coordinated policy responses upheld growth. Supportive fiscal policies coupled with monetary expansion absorbed the economic and financial shocks. Importantly, large fiscal packages supported both GDP and employment: Asian countries spent on fiscal stimuli an average of 9.1 percent of 2008 GDP, far larger than the 3.4 percent of the advanced economies.
 For speedier growth, and to sustain employment generation in the long-term, the economy needs a competitive diversification. Cross country comparisons show that growth accelerations are associated with the production and export of non-traditional manufacturing and services, in other words the products “in demand” in the industrialized nations. Hence, development policies should strategically promote a structural transformation toward these “more sophisticated” economic activities, by providing production incentives to new exportables. Policies should promote the manufacturing – and export – of non-traditional manufacturing and services, to foster a market-driven expansion of non-traditional products.
 In Italy’s parliamentary system, proportional representation – i.e.: divisions in the electorate are reflected proportionately in the elected body – and bicameralism – i.e.: the legislative power is equally distributed between the upper (Senate) and lower house (Chamber of Deputies) – impeded for decades the approval of needed structural reforms one.
 Over the years, access to infrastructure and a better educated labor-force will promote the circulation of goods, people and knowledge. A lack of infrastructure and an education of inadequate quality restrain growth, as they hurt SMEs and discourage entry of domestic start-ups and foreign investors.
 As private investment is constrained by a number of institutional factors that are difficult to address in the short run, schemes for more public-private risk sharing are also needed. To alleviate bottlenecks the government should both reduce the risk and increase the returns on private investment. In other words, it is necessary to stimulate risk-sharing among investors – for example, via PPP – by co-financing public works (transport and communications) and in education, by addressing under-provision of training in areas where skills are lacking. At the local level, people’s investment in skill acquisition and organizational capacity only materializes if private returns are appropriable.
 In Asia, as a result of past pressures from domestic employers and foreign investors, most countries’ labor regulation is sufficiently flexible and not financially onerous for employers. In the late 1990s, Korea eliminated the guarantee of lifetime employment but provided policies to compensate. In Singapore and Malaysia employment is not secure but supported by active policies, such as skills training and self-employment promotion. Over the past decade China and Korea reduced restrictions on retrenchment but introduced unemployment insurance. In China, India (e.g.:, the National Rural Employment Guarantee Scheme) and Sri Lanka, where the informal and rural economies are large, governments often used public works, self-employment programs and skills training to reduce unemployment.