Italy - Lost In Stagnation

No end in sight for Italy's growth agony


  1. The real problem facing Italian policymakers is not dealing with the immediate impact of the last recession, or even how to respond to the sharp rise in unemployment it produced. The big issue is the fact that Italy has an appallingly low trend GDP growth rate - possibly even a negative one at this point - and nothing which has happened since the financial crisis ended suggests it is going to to improve radically anytime soon. In fact as the country's population ages there are good reasons to think that the growth outlook could even deteriorate further.

    The hypothesis being explored here is that Itay is facing some sort of long term secular stagnation. As Paul Krugman puts it: "secular stagnation is the claim that underlying changes in the economy, such as slowing growth in the working-age population, have made episodes like the past five years in Europe and the US, and the last 20 years in Japan, likely to happen often. That is, we will often find ourselves facing persistent shortfalls of demand, which can’t be overcome even with near-zero interest rates."

    Despite the fact that fewer young people may mean skill shortages in certain key areas, and in the longer term a tighter labour market, the problem is not basically a supply side one. Rather the heart of the problem is to be found on the demand side. Slowing (and even negative) growth rates among the key age groups for consumption - identified by their willingness to use credit to raise their short term living standards - means that consumption demand starts to stagnate. Faced with this absence of consumption growth corporates cut back on capital investment projects and it is this weak capex phenomenon that is most typical of secular stagnation. Paul Krugman puts it thus:

    "It’s a pretty straightforward point. To have more or less full employment, we need sufficient spending to make use of the economy’s potential. But one important component of spending, investment, is subject to the accelerator effect: the demand for new capital depends on the economy’s rate of growth, rather than the current level of output. So if growth slows due to a falloff in population growth, investment demand falls — potentially pushing the economy into a semi-permanent slump."
  2. As we will see, Italy's working age population growth is not only slowing down, the size of this population group is now apparently decreasing. Italy is the third oldest country on the planet, following Japan and Germany. What to do about secular stagnation remains a question of considerable controversy. Naturally structural reforms - like raising participation rates and retirment ages - can help, but maybe they cannot "solve" the issue in the traditional sense, since maybe there is no "solution" as such.

    Whether or not it is possible to reflate demand in economies which have entered some kind of enduring process of secular stagnation - as Larry Summers obviously thinks you can (or see here) - remains an open question. If a significant part of the problem is demographic - as I explain here and here in the context of Abenomics - then it is hard to see how you can. As even Paul Krugman admits, "If labor force growth and productivity growth are falling, the indicated response is (a) see if there are ways to increase efficiency and (b) if there aren’t, live within your reduced means. A growth slowdown from the supply side is, roughly speaking, a reason to look favorably on structural reform and austerity."

    If Japan offers us the face of the future, then possibly we need to start learning to live with deflation and find ways of managing the impact on the financial sector. As the FT's Martin Wolf so cogently put it in the Japanese context: "monetary policy can't print babies", and one day or another as our workforces accelerate their decline it may be hard to sustain positive growth. Maybe there are some realities looming out there that we are just not ready or able to accept yet.
  3. Hansen's Secular Stagnation Hypothesis

    The US economist Alvin Hansen surmised that the big driver of US economic growth prior to the 1930s had been population growth. Given the fact that he expected US population to fall he, not unrealistically, came to the conclusion that "We are thus rapidly entering a world in which we must fall back upon a more rapid advance of technology than in the past if we are to find private investmentopportunities adequate to maintain full employment. ..."

    He thought technological advance could stimulate investment to fill a gap left by the lack of natural investment growth. Following Adam Smith he recognized that the "rate of investment" is conditioned by the extent of the market (or rather the rate of expansion of the "extent of the market"), but if population was falling rather than rising then the incentive to invest like before wouldn't be there, since the market wouldn't be increasing in "extent". So technology and innovation became more, not less important, just like the situation we face now.

    Hansen was wrong about the demographic dynamics - he didn't foresee the post war baby boom, but then neither did the demographers he relied on. (For more on this see Richard Easterlin,"The American Baby Boomin Historical Perspective", 1962). But if we look at the situation we face today there is a lot less uncertainty about the population outlook over the next 10 to 20 years, especially when it comes to working age population dynamics. From the experience in Japan it seems it is working age population and not total population that really matters in terms of macroeconomic effects. Declining inflation/deflation correlates much more strongly with working age population dynamics than it does with monetary policy.(See Bank of Japan formerGovernor Masaaki Shirakawa here).

    In fact, Italy's working age population peaked during 2014, and it has since been declining. At least according to the Italian labour force survey. So if this data is accurate it fits the picture described by Hansen admirably. Plus, Italy's economy is now fighting a constant battle to avoid entering into long term deflation.
  4. Hansen spoke of "sickly recoveries which die in their infancy and depressions which feed on themselves." Where unemployment remains untractably high. Italy seems to have the high unemployment, and the depression which feeds on itself, but we rarely see much sign of recovery, even a sickly one.
  5. Even though Italy's economy should return to growth in 2015, and consumer confidence is running very high, hard economic data still suggest growth will remain very weak. But then if Italian trend growth has slumped below zero, then even small positive growth could be considered "above par".
  6. Despite the continuing stagnation Prime Minister Renzi insists that his government's economic strategy is sound and will lift the country out of crisis.In a lengthy interview broadcast on La7 television following the announcement of yet another set of negative GDP results, Renzi said that his government was determined to get the economy back on track, but in due course. "We will work better and harder, but I promised to change direction, not to change the universe in three months time," Renzi said, adding that only a "comic book superhero" could turn around the economy in a matter of months. "Calmly, serenely, we are taking this country by the hand and pulling it out of the crisis," Renzi told listeners.
  7. Could Mario Draghi Implementing QE At The ECB Possibly Help Matteo Renzi Raise the Italian Deficit?

    What a convoluted title! Still, the lack of formal elegance might just be compensated for by its communicative efficacy. The aim of the above header is to link two names in people's minds, both of them Italian: Mario Draghi and Matteo Renzi. Naturally the idea is not original, the FT's Peter Spiegel published an entire blog post ( Does Renzi owe his job to Draghi?) trying to establish some sort of connection between the arrival in office of Italy's Matteo Renzi and the last German Constitutional Court ruling - in the process casting the central bank President in the role of midwife. Indeed, according to the FT, at the time of his appointment Italy was rife with rumours about what might actually lie behind Renzi's meteoric rise, and again the role alloted to Mr Draghi seems to be rather more than an incidental one.

    But the argument here is not about rumour, nor is it about speculation - beyond, that is, speculation about what the ECB might be capable of doing in its campaign to keep the Eurozone deflation menace at bay. Rather than conspiracies (real or imagined) it is about coincidences and the role they so often play in shaping events and outcomes. In this sense the fact that Mario Renzi took over the helm of Italy's government just a short time after the German Constitutional Court ruled on the ECB's Outright Monetary Transactions (OMT) programme (suggesting it might be illegal) has real potential.

    What we could call the "Spiegel hypothesis" suggests the driving force for the "unholy alliance" which may or may not have been forged between Matteo Renzi and Mario Draghi would be found in the latter's interest in getting prime minister Letta out of office before moving forward with plans for QE. Pressure from within Germany about opening a bond purchasing facility for a heavily indebted Italian government which was enjoying cheaper bond yields but was manifestly not advancing with its reform programme would have been too strong to withstand. To open the door to QE, Italy had to change, and Draghi may well have judged that Matteo Renzi was the best candidate to achieve that end.

    But now that we have QE - assuming that in the end it doesn't get tapered early - we may have the ideal conditions for the ECB leader returning the favour, and helping Mr Renzi activate a more stimulatory fiscal policy.

    So far Italy has not been given permission to raise its fiscal deficit over the 3% level, but in February the EU Commission did say it had decided not to initiate disciplinary measures against the country over the rising government debt level. At the same time the Renzi government is steadily easing up on austerity. It is currently "mulling" €1.8bn in new fiscal stimulus measures according to the Financial Times on April 12. Mr Renzi told reporters that some money had been “left on the side". He also confirmed that the government still intended to make €10bn worth of spending cuts in 2016, bringing cumulative savings for 2014-16 to €28bn. That is still €6bn short of the original three-year plan set by Italy’s former spending supremo Carlo Cottarelli in a March 2014 report, made public only at the start of April. Mr Cottarelli, a former director of the International Monetary Fund, resigned in October because of differences with Mr Renzi’s government over his spending restraint strategy. It is also worth bearing in mind that Italy's economy is still underperforming on the nominal GDP projections on which the report was based, so the funding shortfall is likely to be worse than the above numbers suggest.
  8. The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP (or GDP at current rather than constant prices). If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even continue to contract (as has happened in Japan). The result is that the gross government debt to GDP ratio rises hit 132.1% at the end of 2014.
  9. One of the arguments frequently advanced about how this dynamic could be turned around would be for Italy to run a "large" primary budget surplus. Now the emphasis here is on large since the country has in fact run a primary surplus (income - expenditure before paying debt interest) since the early 1990s, but that hasn't stopped the weight of the debt climbing and climbing.

    The IMF, in their 2013 Fiscal Monitor outlined a scenario in which the obligations of heavily indebted European sovereigns first stabilise, and then fall to the 60% level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables, and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. As they point out, the heavier the debt, the higher the interest rate and the slower the growth rate, the larger the requisite surplus. In fact they found that the average primary surplus required in the decade 2020-2030 was 5.6% for Ireland, 6.6% for Italy, 5.9% for Portugal, 4.0% for Spain, and 7.2% for Greece.

    Is it plausible that Italy could run an average primary surplus of 6.6% of GDP over a decade? Hardly - in particular this implies that on average, every year, the government would be draining out 6.6% of GDP from domestic demand via taxation. Yet as I have noted many times, domestic demand is precisely the weak point in the Italian economy (secular stagnation, ageing population).