Italy may jump ahead leaving its government behind

From outside Italy, it is often hard to understand what is going on in the country. We have thus asked Benedicta Marzinotto from the University of Udine and Chatham House to explain the current economic and political situation to us.

The latest available data for the Italian economy have surprised on the upside. As early as September 2006, the Italian government was expecting 2007 economic growth to pick up by only 1.1% from the previous year. Now the forecast is for this year’s national output to rise by 2.3% from 2006 (updated on 8 June 2007). This comes as largely unexpected, not least because Italy is back into political turmoil against the difficulties in passing any piece of legislation when the government majority is as thin as 3 seats ahead of the opposition (in the upper house).

What lies beneath Italy’s stronger outlook? What are its fiscal policy implications? And, why is the political situation not a threat to the possible recovery?

First of all, the news about the Italian economy experiencing a rebound in economic activity should not be exaggerated. At the end of the day, in 2006, Italy registered a growth rate of 1.9%, which that was still below the euro-zone average and that followed a year in which growth had been nil. Apart from this, there is no doubt that the country is doing better than generally expected thanks to a strong export performance that owes to the German upswing. Thus, domestic industrial production has been rising mainly thanks to external demand of capital and intermediate goods. According to ISAE (Institute for Economic Studies and Analysis), Q2 industrial output should grow by 0.6% from the previous quarter after some deceleration in Q1. At the same time, however, private consumption remains overall subdued even if, in the first quarter, it was rising at its fastest since 2004. The underlying weakness of consumer spending is also a consequence of the fact that Italian authorities opted for a significant rise in fiscal pressure over the last year to finance public deficit reduction. As a matter of fact, fiscal pressure rose to 42.3% from 40.6% in 2005 following a 12.4% increase in direct taxation. Looking ahead, the prospect is rosy. Germany will continue growing as export-led growth should feed to the consumer. It will drive Italian GDP upwards! The latest available survey-based data confirm the optimism of Italian producers, who admit the rise in orders of capital goods from abroad, and especially from France and Germany. In addition, the fact that Italian inflation is decelerating and reached in May a rate of 1.9% -slightly below the ECB’s inflation target and below German inflation for the same month (2%)- speaks in favour of a slight gain in intra-EMU competitiveness, and thus of a possible further strengthening of the country’s exports.

Strong economic growth is a blessing for public coffers. Because discretionary fiscal measures are based on government GDP growth projections, faster-than-expected growth has maximised incomes from revenues creating a bunch of financial resources (the so-called “tesoretto”) now at the disposal of government authorities. Meant to anticipate the main contents of the government’s 2008 financial bill, the financial planning document (Dpef) due on 28 June is expected to provide some indications regarding the possible destination of the “tesoretto”, whilst the entity of these resources remains subject of debate. The OECD presses for Italy to use the extra-revenues to reduce the country’s enormous public debt, which in 2006 reached 106.8% of GDP against an average of 69% in the rest of the euro-zone. At present, the government is in consultations with the social partners, whom have to be consulted by law before the submission of the Dpef. Provided that there are really resources left over from the previous financial year*, the most likely scenario is that half of them is used to finance the public debt and the other half utilised to improve the welfare of dependent workers, those that have mostly borne the costs of greater fiscal pressure over the last year, considering that the bulk of the additional revenues came from direct taxation that typically hit those that are in dependent work. The benefits should take the form of some relief on the so-called ICI, a tax which owners of real estate, be it buildings, building sites and land, have to pay to the local government, whatever the use and destination of the property.

The other burning issue on the agenda is pension reform. In 1995, Italy put in place one of the most ambitious pension reform of all EU countries. That reform foresaw adjustments to the system every 10 years. The previous government under prime minister Silvio Berlusconi failed to change the co-efficient used to calculate pension entitlements to reflect rising life expectancy. At the same time, the Berlusconi government had passed a law that raises the retirement age to 60 from 57 starting with January 2008. Still, it is unlikely that the current government agrees to increase the retirement age at once. The most likely outcome is for a gradual increase compounded by a system of incentives that rewards those that remain longer in employment. Labour unions might accept this compromise now that the government has agreed to increase minimum pensions by 250 euros in 2007, allowing also for a progressive adjustment to the costs of living in subsequent years.

So far, it all appears business as usual, namely the economy moves in cycles and the politics is just about striking compromises.
There is but one paradox that characterises Italian economics, and not for the first time, and that is unseen in any other European country: the economy can actually flourish, as it is doing now, even if the political situation is in anguish. Prime minister Romano Prodi is in fact finding it difficult to keep his heterogeneous coalition together. It did not help that deputy finance minister Vincenzo Visco was involved in a scandal that saw him transferring a few tax-police officers that were investigating on the failed attempt by the Italian insurer Unipol to take over Banca Nazionale del Lavoro. And the latest financial police scandals have unveiled a sick relationship between politics and economics that resembles the financial scandals of the early 1990s that had brought to the collapse of the First Republic and, with it, of the country’s entire party system. This time, the transition should be smoother than that but not less traumatic. The current government will remain in office until the electoral law is changed and until the centre-left has clearly identified a strong and convincing alternative to centre-right leader Silvio Berlusconi. The spotlight is on Walter Veltroni, the current major of Rome. Yet, to succeed, he needs to bring in a completely new political class: not an easy task!

The puzzle here revolves around the reasons why political instability has not compromised consumer and business confidence. It’s almost as if Italian consumers got so accustomed to instability that they have become immune to political cycles. On their part, the Confederation of Italian industry (Confindustria) is protesting against the government’s lack of activism but it can actually got it alone. The recent recovery is engineered outside Italy and is thus immune to changes in the political situation. The downside is that an export-led recovery might be not sustainable without a comforting and supportive political situation at home. Germany is a case in point. Here, all the traditional manufacturing sectors have been able to resist international competition thanks to government-sponsored investment in research and development, which in itself is a guarantee of the fact that the recent rebound may well be sustainable**. There is but hope for Italy too! Italian producers can self-sustain the current recovery under two conditions. One is that they get a better access to venture capital, provided that EU legislation becomes more venture-capital friendly. The second, strange as it may seem, is that Confindustria -which is also the national employers’ associations- exploits its direct relationship to workers. It is time for a bipartite social pact between employers and employees that recognises differences in productivity across sectors, but that also concedes relatively generous wages to unions in exchange for their willingness to accept further (unpaid) general training and training in IT skills, after the long period of wage moderation in the private sector following the elimination of the wage indexation system in the early 1990s***. Education and training are key to a rise in labour productivity, a structural weakness of the Italian system especially in the service sector. Confindustria needs to abandon the most classical liberalism to accept that, in the absence of a government that sustains consumption by means of generous transfer payments to the most needy or in the absence of a government all together, only wage bargaining can do the job!

* Tito Boeri and Pietro Garibaldi, “Dal tesoretto nascosto al Dpef”, in: www.lavoce.info, 22 May 2007.
** Marcello De Cecco, “Germania, cosa c’è dietro il boom”, in: La Repubblica, Affari & Finanza, 11 June 2007.
*** OECD, “Economic Survey of Italy 2007: Italy’s key challenges”, Paris 2007.

Misplaced scepticism about Germany’s growth potential

Recently, a debate has developed on the long-term growth perspectives of Germany. Wolfgang Munchau and Susanne Mundschenk from Eurointelligence.com have asked me to contribute my views for their website. Here is my – rather optimistic – evaluation:

Not even a year ago, most economists doubted that the German upswing would last beyond the end of 2006. In fact, Germany’s leading academics at that time were still questioning whether the Germany economy would be able to grow by 2 percent in 2006, with forecasts for a significant growth deceleration for 2007 being the norm. Bert Rürup, head of the “council of wise man” advising the government in economic questions said in May 2006, he would be satisfied if growth even reached the government’s forecast of that time, 1.6 percent for 2006.

One year later, with the German economy growing at robust rates, the skeptics have moved to another arena, questioning whether the German economy will be able to sustain this pace of growth. Now it is no longer doubted whether Germany can experience a cyclical upswing, but whether the potential is large enough to allow a growth rate of two percent or more over the medium term.

Adam Posen and Wolfgang Munchau have been the most prominent skeptics. Adam Posen argues that the fact that the German upswing so far has been very intensive in employment (latest figures on regular employment run about 2.5 percent year-on-year) but has relied relatively little on productivity growth hints that German potential growth remains at around a rather dismal 1.5 percent. Wolfgang Munchau comes to similar conclusions, claiming that there have been no meaningful reforms in the education system and the financial sector which could have increased productivity growth and thus potential growth. He also concludes that the most recent upswing in productivity (see chart 1) is rather cyclical than structural.

In my opinion, these conclusions rely on an overly mechanistic understanding of the interaction of potential growth and the business cycle, especially in the wake of past labour market reforms. Both the experience of the United States in the 1990s and ideas from the New Growth Theory hint that these concerns may be overdone. Instead, it looks well possible – and plausible – that Germany is just on a good path to increase its medium term growth performance.

Chart 1

If one looks at the economic data for the U.S. in the early 1990s and Germany now, there are a number of interesting parallels. The U.S. recovery after the 1990/1991 recession started out with very strong job growth. In 1995, the number of persons employed rose with year-on-year rates of up to 3.5 percent (see chart 2). Productivity growth, on the other hand, was weak – in fact much weaker than in Germany today, with efficiency in the American economy barely growing (see chart 1). The reason behind the slow productivity growth was that the welfare reform had increased the incentive to work for the low-qualified and that the cyclical upswing now pulled into the labour market by the millions. As these workers were less productive than the average U.S. worker, this lowered the average productivity.

Chart 2

Something similar is happening in Germany at the moment. Employment is growing strongly with productivity growth picking up only slightly. The labour market reforms, especially Hartz-IV, have increased pressure on the low-qualified to seek employment. An increasing number of Germans now is in low-paid employment, but also receives unemployment assistance, some combination that acts almost like a negative income tax. The number concerned is not trivial: In the past 12 months, the number of long-term-unemployed has fallen by roughly 300,000; the number of people receiving assistance in addition to labour income has grown by 300,000 from early 2006 until October 2006 (more recent data is not available). 300,000 jobs equal a little more than one percent of the number of regular jobs in Germany. Outside the labour market for the low-qualified, German productivity growth is impressive. Gesamtmetall, the employer’s federation for the metal sector, puts current productivity growth in its member companies at a staggering 7.6 percent year-on-year (albeit one has to note that this is productivity growth per employee rather than per hour worked).

The interesting question raised by Adam Posen is: What is happening when the vast pool of unemployed is exhausted and put into employment. Here again, a look towards the U.S. might be helpful: In America, growth did not stop at the moment when the low qualified were absorbed into the labour market. In the late 1990s, employment growth was only comparably weak, while productivity growth suddenly improved. On a microeconomic level, firms started to invest more in productivity enhancement when they were not able to hire cheap labour anymore. In addition, the effect which statistically depressed productivity growth due to the inflow of unqualified labour into employment vanished. It took until 1998 that U.S. productivity growth persistently rose above two percent. Consequently, the economy managed to continue to grow with rates of about 4 percent, even faster than in the years before when employment growth was high. There is no reason why something similar should not happen in Germany.

Second, it is highly questionable if productivity growth is simply enhanced by improving the structure of the education system or of the banking sector. Instead, there are good arguments that these reforms are neither necessary nor sufficient conditions for a pick-up in productivity growth. This again becomes evident if we take a look at the United States over the past 15 years. At the beginning of the 1990s, when the U.S. economy was just getting out of the recession, the general mood about the medium and long-term prospect of the U.S. was grim. General perception was that the education system was a mess (with the possible exception of the top-end institutions of higher education), high-school drop-out rates were high, and even the share of functionally illiterate among the high-school graduates was significant. The lack in education, so the perception of that time, were behind the underperformance of U.S. productivity growth vis-à-vis Germany or Japan.

Interestingly, the concerns about problems of the U.S. education system were completely forgotten when productivity growth in America picked up in the late 1990s. It is safe to say that the broad education system in the U.S. was not improved much over the decade – neither on the high-school level nor on the level of many of the community and state colleges in which the larger part of the American workforce receives its secondary education. Even today, the average performance of American high school students is rather weak in international comparison. However, these problems did not hinder U.S. productivity growth from picking up around the turn of the century.

So, what had happened in the U.S.? Economists still do not completely agree, but the mostly accepted story is that the strong investment in equipment, IT infrastructure and software since the late 1990s and the dissemination of this technology through the economy has made the productivity increases possible which were then harvested in times of good cyclical growth. This is exactly what New Growth Theory would teach us to expect. Technological progress is embodied in new capital goods and its benefits are felt only with a time lag after the initial investment.

German companies might not have invested as much as their U.S. counterparts in IT infrastructure after the bust of the New Economy bubble, but it is safe to say that all larger German companies by now are fairly up-to-date when it comes to IT equipments. Internet, E-Mails, Blackberries and even supply-chain management in retailing is not much behind that of the U.S. The productivity gains experienced in the U.S. over the past years should thus also be possible for German companies. In addition, capital spending on equipment and software has picked up sharply lately. Measured as a share of GDP, Germany has now higher investment in new equipment than the average of the euro-zone, a change in relative positions compared to 2002 or 2003. Given that the new equipment comes with the latest technology (and often some components which enhance their productivity by the use of latest IT technology), this investment boost can be expected to have also positive effects on total factor productivity.

A final argument of the growth sceptics is that German companies have not been investing much in research and development and are thus not well positioned for an improvement of their products in the years to come. However, even this fact might quickly change. As we know from recent work by Harvard economist Philippe Aghion, in economies with imperfect credit markets, firms vary their R&D expenditure strongly with the business cycle. As a number of German companies have been credit-constrained due to problems in the banking sector from 2001 to 2005, this effect might be important to understand the German R&D dynamics. Now, with profits growing strongly, firms have more liquidity to invest in their R&D projects and there is a lot of anecdotal evidence that they are indeed pursuing this path.

So, Adam Posen might be right that the current upswing in Germany has not been triggered by an exogenous increase of the growth potential and especially productivity. However, the elements are in place that the German upswing will endogenously increase the German potential and thus generate the improvement in productivity necessary to sustain a long and upswing with annual growth rates of two percent or more.

The implications of the EU summit for EMU governance

The results of the EU summit have been extensively commented since last Sunday. However, we at Eurozone Watch believe that a number of aspects which are relevant for economic governance in the EMU have not been elaborated in the debate so far.

The first concerns the decision to eliminate free competition from the European Union’s objectives. Firstly, we in principle agree that free competition need not necessarily be listed as an objective of the European Union. Free competition is an instrument to achive growth and international competitiveness, not an end in itself. Thus, the case for the elimination from the Union’s objectives can be argued, without necessarily questioning as such the concept of free competition within the Single Market.

The potential political consequences of the highly symbolic decision to change the objectives defined in the European Union Treaty under the current circumstances yet have to be carefully assessed. Eliminating competition from the Union’s goals is the major concession to the French President Nicolas Sarkozy. It is “sold” as a response to the mostly leftist critique in the French debate on the Constitutional Treaty which stamped the EU’s Common Market and competition policies as a Trojan horse of globalisation. Last week-end’s decision was celebrated as a major victory by Sarkozy in some French media. Some interpretations went as far as celebrating the beginning of an end to competition as a functioning principle of single market.

Does the decision mean that the functioning of competition is at risk once the new Treaty enters into force? The EU Commission in our view will not be automatically weakened. It still possesses the same means to pursue its previous tasks in subsidy and merger control. But, in order to affirm its role, it may even toughen its implementation of the EU’s competition policy, especially as national protectionism within the EU’s borders has increased in recent years.

So, instead of bringing relaxation, the decision to change the Union’s goal may turn out to be another element that fuels tensions between the Commission and the national EU governments. Given the reflex by national policy makers to engage in anti-Brussels-rhetoric, these developments may in fact lower public support for integration. After all, with the Coucil’s decision to revise the Union’s goals which have been part of the EC’s Treaties ever since integration started, expectations were raised that something would substantially change. But there is not much reason to assume it really will.

On the contrary. If tensions on the EU’s competition policy rise, they will make the still embryonic discussions on the question whether the EU competition policy as such has to be reformed in view of global competition surely more difficult. The fronts between those which argue the case for a revision of the policy (notably its underlying concept of the relevant market) in oder to promote the emergence of “European champions” and those who cling to the traditional concept of a maximum of competition within the Union’s borders to bring about globally competitive players, are likely to harden.

From an EMU perspective, it would be infortunate if these developments led to even lesser dynamics in the integration of the markets. The political will to go forward notably with the integration of capital, labour and services markets has in any case declined in recent years, as the steps that would be coming up next touch on the more sensitive issues, given the degree of integration already achieved. Insufficient market integration yet remains one of the obstacles to a smooth functioning of the EMU, especially as the fiscal regime in EMU likewise does not meet the challenges of a currency union.

The second aspect concerns the overall tense political climate at the summit. The German government had set itself a huge task to forge a compromise on the new Treaty’s elements before launching the Intergovernmental Conference. The most problematic conflicts of interest where between the “ratifiers” and the EMU-outs (Poland, the UK, the Czech Republic). France and the Netherlands, both non-ratifiers after failed referenda but Eurozone countries, contributed less to the complications to the summit (although they, in contrast to the non-ratifiers who did not even attempt to ratify the Treaty, indeed had a legitimate case to make after a democratic rejection of the Treaty).

Despite this seeming harmony between the Eurozone countries, it also has to be seen soberly that none of the EMU countries coalised to create an outreaching political impulse to the EU or EMU. From that perspective, the EU summit and its result in our view (and in contrast to many of the relieved comments in the mass media) didn’t as such create any potential for future dynamics.

The summit, yet, confirmed one tendency we commented on amply before: Nicolas Sarkozy again positioned himself as the dealmaker (which was actually the Presidency’s job) and he seems willing to act as an agenda setter in EU affairs as of now and up to the French EU Presidency in the second semester 2008.

Well before the EU summit, he announced that he would await last week-ends meeting and the end of the German Presidency before he comes forward with suggestions how to reform the Eurozone (he announced a French-Italian initiative on that matter). His first occasion to put his ideas up for discussion will be the July Ecofin meeting – which he as as French Head of State will attend against all EU traditions along with his new Finance Minister Christine Lagarde.

As a third aspect we underline that last week-end’s results are likely to contribute to asymmetric integration processes (two-speed or core Europe). The UK negotiated further opt-outs, which – at times of the Maastricht Treaty were the big exception with the EMU – now form part of European normality. The tendency towards patch-work coalitions along certain policy areas will increase. They are there already, most visibly since the start of EMU (with the UK, Denmark and Sweden being long-term opt-outs), but also in other policy fields such as justice and home affairs.

If the UK effectively makes use of its new options, the consesquence will be that the barely hidden political gap between the UK and continental Europe is likely to widen. The flip side of this general trend to lesser symmetric integration may be that the Eurozone affirms its status of the core of Europe. Political dynamics to establish the currency zone also as a political Union are yet to follow. The UK, with its newly demonstrated interest to opt-out from policy fields, will be less and less able to prevent a further institutionalisation and deepening of the Eurozone – if this is what the EMU countries decide to go for, of course.

Is Sarkozy’s “fiscal shock” the right thing for France?

Third part of our series on Sarkozy and Europe

After his election as a president, Nicolas Sarkozy did not lose any time pushing forward with his economic and fiscal policy agenda. Even before the first round of the parliamentary elections this week-end (in which Sarkozy’s party did extremely well), a number of legislative initiatives have been prepared to be pushed through the Assemblée Nationale over the summer. According to Sarkozy, France needs now a “fiscal shock”.

Among the measures brought forward by Sarkozy are the following (initiatives with little or no macroeconomic effect or costs have been omitted):

• Overtime payment: overtime payment will be excluded from taxes and social security contribution. For full time employees, this applies to all voluntary hours in excess of the original 35 hours work-week. For part-time employees, tax free overtime may only reach 10 percent of the regular work time. In addition, the companies’ social contributions for overtime will also cut. However, this money does not necessarily end up with the business sector: At the same time, the legal overtime surcharge small companies have to pay will be increased from 10 to 25 percent.
• Working students: Students will be exempted from the income tax
• Mortgage subsidies: New home buyers will be allowed to deduct mortgage payments up to a certain amount from their taxes for the first five years after having acquired a new house or apartment.
• Inheritance taxes will be cut.
• Limit on direct taxes: No one will have to pay more than 50 percent of direct taxes (social security contributions excluded), starting on January 1, 2008.

All in all, the costs of these proposals add up to probably as much as € 15 bn, or 0.75 percent of French GDP. Measures introduced into the legislative process last Wednesday already amount to € 11 bn. So far, Sarkozy has not presented any ideas of how to finance this spending spree, but his call for a “fiscal shock” and his attacks on the Stability and Growth pact hint that he is going to increase the government deficit.

To judge these measures, the important question is: What does France really need at the moment? Our regular guest contributor David Milleker, chief economist of Union Investment, has long argued that France needs some supply side reforms bolstering the profitability of the French corporate sector (see his contribution for the Financial Times Deutschland’s website here or his comment to our post on the “TVA sociale” here). David used to argue that the profitability of the French corporate sector is low in international comparison and that thus investment is low. Since supply side reforms tend to suppress demand in the short run, David has been in favour of a combined approach of supply and demand policies for France.

A look at the investment ratio in France supports David’s analysis of problems of the French business sector (see figure). Investment in equipment as a share of GDP has long been trailing behind the rest of EMU. In addition, while investment has picked up sharply in Germany, it has only risen slightly in France. This might be an indication that the French corporate sector indeed is not in a very good position, most likely because the French economy has lost price competitiveness vis-à-vis Germany in the past years of aggressive German wage restraint.

Thus, if Sarkozy would use a strategy of combined supply and demand policies, improving competitiveness while bolstering domestic demand, there would not be much to object. If he would for example introduce his “social VAT”, increasing the VAT tax while cutting social security contributions (as the Germans have done) and at the same time use his fiscal policy to bolster demand so that the VAT shock does not hit the domestic economy, this might amount to a wise strategy. One could also make the point for relaxing rules about employment protection and at the same time hand workers a tax cut, as this would also improve supply conditions while limiting the short-term negative outfall on demand.

However, Sarkozy’s program does not meet this aim. There is basically nothing in the proposal which improves France’s competitiveness. While Sarkozy has said that he would replace the large number of different labour contracts in France by one which provieds less protection, nothing to this end has been introduced in the legislative process and there are no specifics about his plan known yet. It remains to be seen if Sarkozy will ever come back to this project. However, even if employment protection is slightly loosened, this will provide little help to France’s ailing productivity.

The proposed cut in taxation on overtime is set to be redistributed to a large share towards the households as Sarkozy is at the same time increasing the mandatory overtime pay. The taxation limit to 50 percent will most likely only apply to very wealthy individuals and will not help the corporate sector much. Relieving working students from income tax will most likely lead to new strategies to have someone counted as a student, not to lower labour costs. Most students do not earn enough to profit from this exemption anyway. The cut in marginal taxes on overtime will increase the French’s willingness to work beyond their 35 hour week, but labour shortages have not been a problem for the French economy over the past years, so the positive macroeconomic effect of this measure should be small. In fact, the cut in taxation for overtime payment might even jeopardize the Lisbon target of increasing the employment ratio: Under the new rules, relative to the status quo, it becomes more attractive having the old employees working longer hours than hiring new workers. In the context of women’s participation in the labour market, some extra hours for the husband might now seem more attractive than women remaining in the labour force.

In addition, the demand stimulus from Sarkozy’s program is hard to evaluate. The tax deductability of mortgage payments might well have quite a higher multiplier: As the new tax rules might lead to an even stronger house price increase as hitherto, this might also give another boost to the French consumption which is driven by the wealth effect. However, one should note that this increases the risks for a bursting of the bubble in the real estate market and serious consequences for the economy further down the road. The cuts in the inheritance tax and the limit on overall direct taxation in contrast will only have very limited effect.

Thus, overall, it is safe to say that Sarkozy’s measures so fay rely only on demand stimulus, something which the French economy does not really need given the already strong demand in the rest of Europe and the still robust growth in France (the OECD sees French GDP growth at 2.2 percent both for this and next year). France’s problems, on the other hand, are not really tackled. For the rest of the Eurozone, Sarkozy’s policies are quite dismal: France is now fuelling the boom exactly at a moment in which the ECB is debating on how high it has to raise the interest rate in order to prevent the European economy from overheating. This is exactly the kind of fiscal policy a monetary union does not need.