19 November 2022
I have just enjoyed a fact-finding trip to the Emilia-Romagna region of Italy. Naturally, I indulged myself with the gastronomic delights of Bologna, Parma, and Modena; as well as marvelled at the mosaics in Ravenna. On the economic front, to be sure, Italy has had little to cheer about in recent years. Indeed, the Chart above illustrates real GDP per capita has stagnated since 2000; diverging sharply from key European rivals. Alarmingly, despite being a G7 nation, Italian output per head is now below the EU average.
Fortunately, I have returned a bit more upbeat about Italy’s near-term prospects. For example, following the country’s horrific Covid experience, Italy’s economic recovery has outpaced both the Eurozone average and key regional and G7 competitors (Chart above). Especially encouraging, the level of employment and the labour force participation rate are at their highest levels in 20 years.
What lies behind the recently improved performance? Italy has been a major beneficiary of the EU’s post-Covid Next Generation program supporting recovery and improving resilience (Chart above). In particular, the plan funds supply-side investments aimed at mitigating climate change and expanding the digital economy. With Italy benefiting from additional resources through 2025/26, economic growth may outperform the Eurozone in the next two years.
However, with near-term monetary and fiscal policies likely to remain restrictive, only radical, sustained supply-side reforms will remedy Italy’s long economic malaise. Indeed, continued stagnant medium-term GDP growth would widen further the gap with affluent European neighbours; with Italy potentially becoming a second-tier European economy. Such an outcome could pave the way for additional fiscal crises at some stage.
Demand Management: Little Room to Maneuver
Can stimulative macro-economic policies improve Italy’s near-term growth prospects. Probably not. To be sure, Italian and Eurozone inflation has peaked. And, Italy’s price outlook is better than the European average: Italy’s 1.7% inflation rate is below the Eurozone’s 2.9%. Moreover, the outlook for core inflation is also better, as Italian wages are rising at half the 5% rate throughout Euroland. Rightly, however, the ECB’s priority will be to lower regional inflation towards the 2% target. Therefore, monetary policy will remain restricitve through 2024 at least. With the period of quantitative easing now over, European real interest rates will be higher and positive in the years ahead.
Likewise Italian fiscal policy is likely to be restrictive. Prior to the pandemic, Italy was able to stabilise its bloated government debt/GDP ratio through a combination of primary budget surpluses (non-interest) and low interest payments (Chart above). As in other countries, Covid-era measures led to big deficits and rising debt. However, with higher real interest rates, stabilising the debt ratio again will be more difficult. In particular, if medium-term GDP growth remains stagnant, cumulative fiscal tighening of at least 2% of GDP will probably be necessary over the next few years.
Such an adjustment will require a huge shift in public sector spending priorities. Government outlays already account for 55% of GDP compared to 49% and 37% in the Eurozone and USA respectively. And, the budgetary impact of an aging population will exceed that of other countries (Chart above). Likewise, Italy’s tax burden of 50% of GDP is higher than 46% and 32% in Europe and USA respectively. More robust long-term economic growth would help reduce the pain of the adjustment. Without it, however, Italy’s debt ratio could approach 200% of GDP within 15-20 years.
Identifying the Causes of the Malaise
Identifying the key factors behind Italy’s economic underperformance is not too difficult. Economists focus on the availability of labour and capital, and the efficiency of the use of these key inputs. Most importantly, Italian productivity has stagnated for nearly 30 year, and the gap with key partners has widened sharply (Chart above)! As has been Italy’s experience, without efficiency gains, households’ real incomes, economic activity, and standards of living do not improve. The problem is pervasive throughout the economy, but service sector productivity has lagged in particular (next Chart), which has been the key growth sector in other advanced nations in recent decades.
Likewise, Italy’s investment rate (in both the private and public sectors) lags significantly behind other countries, reflecting a weak supply of capital (next Chart).
Yet again, the lack of investment is most pronounced in the service sector (following Figure). The link between tepid capital spending and flagging productivity is clear.
Furthermore, demographic shifts — lower fertility rates and longer life expectancy — are leading to a sharp aging of the population (next Chart). These trends pose a serious threat to Italian labour supply (as well as the government budget deficit) both now and in coming decades.
To be sure, these patterns exist in many European (and Asian) nations. However, the following Chart indicates the consequences on labour supply will be particularly acute in Italy.
Supply-Side Reform: Action Needed on All Fronts
Deregulation and Business Investment
While identifying the causes is pretty straightforward, the remedies are not as easily implemented (the OECD, EU, and IMF provide useful reports, which I recommend, offering lots of policy recommendations). However, urgent action is need on on all three fronts, and I will put forward options involving potential opportunities/pitfalls for investors.
Boosting capital spending will require improvements in the business environment. In the most recent World Economic Forum Global Competitiveness Report, Italy ranked 30th amongst 141 nations. The other G7 nations all ranked in the top 15. The Chart above highlights key weaknesses: over-regulation, an unreliable legal/judicial framework, inconsistent government policymaking (especially high debt/deficits), labour market inflexibility and inadequate workforce skills, crime, insufficient IT deployment, and poor service sector development and competitiveness. Especially onerous regulation in the service sector has led to under-investment and weak growth in this key area (next Chart).
Solving the Productivity Puzzle
Of course, high capital spending should help boost productivity, but other areas also need addressing. In particular, spending on education lags behind other OECD nations. The next Chart illustrates the relatively small proportion of people with a university education, and the high share of the population with low skills (who might be challenged by immigrants). Even students in secondary school achieve results lagging other advanced nations, especially in vital science, math, and reading categories (following Chart).
In addition, R&D spending in both the private and public sectors is lower than in competitor nations (next Chart). As the government addresses future budgetary challenges, it’s important R&D is maintained.
A key aim of Italy’s EU-supporter Recovery and Resiliency Plan (NRRP) is to jumpstart the development of the digital economy. Workers have low IT skills and businesses have been slow to invest in information technology (next Chart provides just one metric). Likewise, the public sector’s effectiveness has been hampered by low IT usage.
Boosting Labour Supply
What can be done to address the shrinking labour force? First of all, Italy’s employment rate is well below Europe’s average (next Chart). Female participation is particularly low — a potential source of labour supply. Until recently, most new employment oppurtunities were either temporary, part-time or in the informal sector with low pay and job insecurity. Creation of high-paying, full-time jobs would lift the employment rate.
Italy’s “wage gap” — the difference between salaries and take-home compensation — is amongst the highest in the OECD (next Chart). High social security levies and high tax rates provide disincentives both to work and to hire.
Immigration is highly controversial in Italy, as it is elsewhere. However, foreign workers represent a relative small share of the nation’s population, and could play an important role in addressing labour shortages (next Chart).
However, poorly-educated, low-skilled Italian workers (particurly young people) could be especially challenged by low-cost foreign labour. The share of Italy’s youths not in education, employment or training is amongst Europe’s highest (next Chart). Educating/training young people will reduce the threat posed by immigrants.
In addition, roughly 180,000 Italians emmigrate every year, usually the most well educated. Poor job prospects at home, the lack of career advancement, and higher compensation abroad (the pay premium is roughly 50% for an employee with 5 years experience) contribute to this talent drain. Increasing immigration by 30% annually, e.g. an additional 100,000 new arrivals per year (towards the EU average as a percent of the local population) combined with efforts to curb high-skilled emmigration would offset the projected declines in the labour force.
Energy Security and Climate Change
Climate investments are a key component in Italy’s NRRP. Italy’s green-house gas emissions per capita are below the EU average, but additional investment is required to meet its 2030/2050 goals. The Chart above indicates Italy is an efficient user of energy (low energy intensity). However, the country is highly dependent on natural gas: representing 40% of overall energy consumption and 54% of electricity generation (compared to the EU average of 20%). Without nuclear power, the share of renewables will need to increase (now lagging the EU 27% and 31% respectively in electricity generation). Meanwhile, Italy appears on track to eliminate its reliance on Russian energy supplies by 2025 ( which represented roughly 40% of total energy consumption prior to the Ukraine war).