Monday, October 31, 2011

Does Italy Really Deserve To Be A Scary Halloween Story?

Last week after the latest European summit, most of the markets were jumping, with the Russell Index rising over 5% on Thursday, Oct. 28. Then word came that the spread over their German equivalents for Italian ten-year bonds had risen to over 6%, pushing the level in August just before the ECB began buying Italian and Spanish bonds, with the ECB this time supposedly doing so again, but not succeeding in halting the rise (maybe needed to do more, but the Germans and their constitution won't let them?). Now everyone is freaking out that perceived failures by Italy to reform will doom the euro and the EU, with the Daily Mail even fancifully forecasting major European war by 2018. Is all this really justified?

Of course, the simple answer is "yes" because the markets say so, and it is clear that Italy is so big that nobody can bail it out if it defaults. But how likely is that really? Yes, its debt-GDP ratio is about 120%, but it has had a greater than 100% such ratio for a majority of years over the last half century, with nobody much bothered as Italians have a high savings rate and most of this debt is internally owned. Indeed, for years Italy was the poster boy for Ricardian equivalence (high deficits, but high savings rate offsetting its stimulative effects). Furthermore, Italy is running a primary fiscal surplus, before interest payments on debt, generally viewed as not warranting such panic. More is going on here, and I think there are two parts, a short-term one and a long-term one.

The short-term one is simple: Silvio Berlusconi. Both Merkel and Sarkozy have barely been able to restrain their justified contempt for this 75-year old clown, who continues to hang onto power despite disastrous polls and multiple investigations about matters personally fiscal and sexual. His reform plan might actually be credible, although much of the problem is outsiders do not think he can get it through parliament, and his coalition is as shakey and quakey as they come. The centerpiece of raising the general retirement age from 65 to 67 looks like a mostly symbolic matter, given the budget is already in primary surplus. But, even though he continues to be "Il Cavaliere" strutting about in fancy suits on his TV channels and the front pages of the Italian papers, his support is less than 25%, reportedly confined mostly to elderly rural women who have not yet heard that the Roman Catholic Church has tired of fronting for him. He is the short term problem, and indeed he should go, as everybody says. But, the rascal is hard to get rid of, surviving a no-confidence vote (narrowly) a few weeks ago.

The longer term problem is that growth has slowed, now a ten year phenomenon of barely 1% per year growth. This is what has opened up the divergence of competitiveness between Italy and Germany and made for a need for Italy to devalue, thus ultimately straining the Eurozone with trade imbalances. It is easy to forget that Italy was a growth wonder back in the 70s, 80s, and even 90s, with its small clusters of exporting firms praised by Michael Porter. It is the increasing weakness of these firms that lies at the heart of Italy's longer run problems, and it is not obvious what can be done about it. Some say they are too small to deal with larger Chinese competitors or even the Mittelstand firms of Germany. I am in Florence where high-end textiles have been a big deal since the Benedictines produced them in the 1200s. Gucci, Pucci, and Salvatore Ferragamo all started here. Gucci has a production facility a block and a half from where I am staying, but they were bought out long ago by LvMH, the giant French firm. They are still hanging in there. Salvatore Ferragamo is still run by a widely admired family member, but can they continue to produce in Italy rather than China? I do not know. Many call for labor reforms in Italy, and some would help (including of academia), but this is indeed a longer term problem, and getting growth going again will not be helped by forcing a useless recapitalization of banks that will probably lead to cutbacks in lending and a return to outright recession in much of Europe.


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