Meanwhile, there was also a bit of improvement on Friday, but dollar interbank funding stresses still worsened significantly over the course of the week as European banks seemingly continued to have worsening dollar liquidity issues. And various other markets across the globe also started to price worries about the potential impact of heavy asset sales and deleveraging by European banks seeking to reach 9% core tier 1 capital ratios by mid-2012 and continuing to face struggles with term funding. Our European banks team estimates that there could be a €1.5-2.5 trillion deleveraging over the next 18 months by European banks, with "risks to SME lending, trade finance, syndicated lending, asset leasing, CEE banking, and parts of wholesale/investment banking" and the prospect of a grinding credit crunch in peripheral Europe (see European Banks: What Are the Risks of EUR1.5-2.5tr Deleveraging? by Huw Van Steenis and team, November 14, 2011). While initially able to remain calm during the early-week turmoil in European sovereign markets, US markets saw more cautious trading in the second half of the week as these concerns rose, supporting long-end Treasuries.
Domestically, incoming economic data continued to look surprisingly solid, again providing some offsetting support to US risk markets from the worsening situation in Europe. The past week saw better-than-expected results for retail sales, industrial production, housing starts, jobless claims and the index of leading economic indicators. Incorporating upside in the retail sales report, we boosted our 4Q consumption estimate to +3.0% from +2.2% and our GDP estimate to +3.5% from +3.3%. We continue to see 3Q growth being revised down to +2.2% from +2.5%. This would leave GDP up 2.9% annualized in the second half, right about what we were forecasting in early July before the turmoil surrounding the debt limit debate and PSI for Greece that led us to cut our estimates in August. Downside risks still appear significant heading into 2012, however, and from the same sources that led to our August forecast revisions, the worsening crisis in Europe and fiscal policy tightening and uncertainty domestically. After another week of no apparent progress, the super committee appears very close to ending without results, as its effective deadline for reaching agreement is probably imminent in order to meet the legal requirements for holding a formal vote by November 23. Outright failure would likely lead to the $1.2 trillion in spending cuts starting in 2013 being triggered, which would add to the scheduled expiration of all the Bush tax cuts at the end of 2012 to create the potential for major fiscal tightening looming for the next year depending on the outcome of the November 2012 elections. Super committee failure also does not leave a clear way forward for considering extension of the payroll tax cut and extended unemployment benefits that expire at the end of this year.
On the week, 2s-30s flattened 17bp to a six-week low of 271bp on good gains at the long end and losses at the short end that were moderate in absolute terms but large relative to the low level of short rates. The 2-year yield rose 6bp to 0.29%, 3-year 3bp to 0.42%, 5-year 2bp to 0.92%, and 7-year 1bp to 1.46%, while the 10-year yield fell 4bp to 2.01% and 30-year 11bp to just below 3.00%. TIPS underperformed badly on tumbling commodity prices and supply pressures at the 10-year auction, though they traded a lot better once the auction was out of the way. Front-month gasoline fell 4.5% to near the lows since February hit in early October, while natural gas saw continued heavy losses, with the December contract off 8% on the week for a 16% drop so far this month, pointing to lower utility bills for consumers in the coming winter heating season on top of the relief from lower gas prices. The 5-year TIPS yield rose 26bp to -0.81%, 10-year yield 8bp to 0.01%, and 30-year 3bp to 0.82%. This left the benchmark 10-year inflation breakeven right at 2.00%, down 13bp on the week but up 13bp from where the 10-year TIPS auction was awarded early Thursday afternoon. With the pullback in shorter-end breakevens so much larger, the 5-year/5-year forward implied inflation breakeven ended the week little changed near 2.25% based on the Fed's constant maturity yield figures. Lower-coupon mortgages underperformed Treasuries by a few ticks on the week, but higher-coupon issues outperformed a bit, Fannie 6s by about 3 ticks, as details of HARP 2.0 released by Fannie Mae and Freddie Mac released Tuesday confirmed market expectations that the changes would not lead to a large increase in refis of high rate mortgages. Economically, the direct impact of the new program continues to look negligible, perhaps lowering annual interest costs for mortgage borrowers by $2-3 billion by the end of 2013, or about 0.02% disposable personal income. In our view, an appropriately more aggressive effort to allow borrowers current on high rate GSE-backed mortgages to refi could have an impact 10-20 times larger than that. This lack of progress must be very frustrating to the Fed, which has watched what is normally one of the most important transmission mechanisms of low rates to the economy be largely blocked by decisions of federal regulators.
There was some improvement Friday, but for the week as a whole interbank lending conditions and shorter-end swap spreads still showed substantial deterioration, symptomatic of a further rise in dollar funding strains at European banks. 3-month Libor continues to set higher every day since late July, and the pace of increase has accelerated in recent days, with a 3.1bp increase over the past week to 0.48778%, more than double the average daily increases seen previously in this relentless grind higher. With the Dec 11, Mar 12, and Jun 12 eurodollar futures contracts losing 8, 12 and 10.5bp on the week, the market is now pricing 3-month Libor to reach 0.66% on December 19, 0.80% on March 19, and 0.815% on June 18, and then stay near that level though mid-2013 even with no change in Fed policy expected. This persistent upward pressure has lifted the spot 3-month Libor spread over the average expected daily fed funds rate to 38bp from a more normal 14bp in late July. The forward Libor/OIS spread for December is now up to 55bp, March 67bp and June 68bp. This has been driven by bigger upward pressure on dollar lending rates in Europe that has been only gradually (but in recent days more quickly) transmitted into US rates. The 3-month dollar lending rate implied by EUR/USD FX forward agreements rose another 20bp over the past week to near 1.72%, levels not seen since early 2009. These funding stresses have been transmitted in a big way into shorter-end swap spreads also, with the benchmark 2-year spread up another 4bp over the past week to 49bp, pulling back somewhat Friday from the first moves over 50bp Wednesday and Thursday since the spring of 2009.
The super committee appears to have made no progress over the past week in discussions between individual members and small groups after meetings of the full committee broke down back on November 7. Outright failure now looks increasingly very likely, which on January 15 would trigger $1.2 trillion in spending cuts starting in calendar 2013. The latest reports late Friday were that talks were shifting to attempts, according to the Washington Post ("Debt super committee: Democrats reject last-ditch Republican offer"), "to develop a smaller ‘Plan B' that would stop far short of the panel's goal of $1.2 trillion in deficit reduction over the next decade". If so, the gap between whatever Congressional leaders might be able to come up with at the last minute and $1.2 trillion will be made up through proportionately smaller across-the-board cuts. The cuts would be mostly in discretionary spending - Medicare, the dominant long-term fiscal problem, would be barely touched - and nearly half in defense, even though defense made up less than 20% of federal spending in fiscal 2011. By law, the super committee has until November 23 to reach a majority agreement on a plan that Congress would then be required to hold a straight up or down vote on - no amendments and no filibustering in the Senate - by December 23. The committee is required to have the Congressional Budget Office score the plan to decide whether it indeed meets the minimum goal of $1.2 trillion in 10-year deficit cuts, and once the CBO has provided the committee its estimates, it must wait a full two days before holding a vote. There appears to be little hope of meeting that deadline now.
The super committee doesn't immediately dissolve on November 23. By law it remains in existence until January 31 with funding continuing for staff expenses, so it could if members wanted to resume the discussions that broke off November 7 and even hold hearings and try again to come together to present a deal. But once November 23 passes without a majority super committee deal having been approved, the law requiring Congress to give a super committee plan a straight up or down vote by December 23 is revoked. Any attempts then to avoid the triggers or more broadly to try to deal with the tax and spending outlook would likely require 60 votes in the Senate to overcome a filibuster and would have to somehow find a way to devise a bill that could make it through both chambers in identical form when members would be free to propose changes and amendments to any plan offered. Assuming super committee failure, the triggered $1.2 trillion in spending cuts seem likely to be an ongoing debate and a key issue in next year's elections. Senator McCain has made clear that he would begin an immediate effort to repeal the defense portions of the scheduled cuts, which Defense Secretary Panetta has portrayed as a "doomsday mechanism". But when the law creating the super committee was drawn up, Republicans demanded that the triggered deficit cuts contain no tax increases and Democrats agreed only if the triggered spending cuts were so heavily towards defense and so lightly towards Medicare, believing that this would force Republicans to accept tax hikes as part of a super committee deal rather than allow the super committee to fail. This clearly doesn't seem to have worked. But Senate Democrats still seem quite likely to demand tax hikes from Republicans to offset repeal of the triggered defense cuts, and House Republicans still seem very unlikely to pass any significant tax hikes.
So, in the increasingly likely event that the $1.2 trillion in relatively defense-heavy spending cuts are triggered - or at least a substantial portion of them are, if some much smaller compromise agreement can be reached at the super committee in its closing hours to meet a portion of the $1.2 trillion minimum - it seems more likely than not that they will remain on the books through the election. This would point to the risk of broad spending cuts of about $100 billion at the start of 2013 from the flat baseline for discretionary spending agreed to in the August debt deal. In addition, all of the Bush tax cuts are scheduled to expire at the start of 2013, raising taxes by about $300 billion a year (give or take, depending on interactions with whatever adjustments are made in the annual fix of the alternative minimum tax). That would be a fiscal tightening of about 2.5% of GDP hitting on January 1, 2013. Depending on the outcome of the elections in November 2012, the actual fiscal tightening seen in 2013 could be less than that, or it could be more, and its form could be quite different from what is on the books through most of next year. But at least the potential for these looming heavy spending cuts and severe tax increases are likely to add to business and consumer cautiousness and make planning difficult through the next year. In the near term, super committee failure eliminates the vehicle through which the White House and Congress were hoping to deal with the payroll tax cut and extended unemployment benefits that expire at the end of the year. There may be a bi-partisan majority in favor of extending these provisions, but getting extension through both houses of Congress without being able to attach them to a super committee bill requiring a straight up or down vote could still be challenging. House Republicans will likely be tempted to attach various other measures they favor to any extension bill, hoping to force the hand of Senate Democrats (and vice versa), which could cause progress towards agreeing to extension to get bogged down in partisan fights.
While fiscal policy and the crisis in Europe remain significant downside risks heading into 2012, economic data released the past week continued to point to solid second half US growth, surprisingly so relative to what were expecting and where we saw near-term downside risks pointing back in August and the first part of September. Industrial production surged 0.7% in October, housing starts only dipped 0.3% after jumping 7.7% in September, the index of leading economic indicators surged 0.9%, the biggest gain of the year, and a surprisingly strong retail sales report led us to further boost our 4Q GDP forecast. Retail sales gained a significantly better-than-expected 0.5% overall in October and 0.6% excluding autos. In line with the slight uptick in unit sales reported by auto companies, motor vehicle sales gained 0.4%, and in line with sluggish chain store sales reports, general merchandise (0.0%), and clothing (-0.7%) were soft. But big upside at electronics and appliance retailers (+3.7%), grocery stores (+1.1%) and non-store retailers (+1.5%), which are primarily internet-only companies, drove another month of robust overall retail sales. The key retail control grouping - sales excluding autos, gas stations and building materials - rose 0.6% in October for a surprisingly strong 6.6% annualized gain in the past three months since consumer sentiment plummeted in early August. We now see 4Q consumption rising 3.0% in 4Q instead of 2.2%. Putting in some partial offsets to this from assumed lower inventories and higher imports, we raised our 4Q GDP forecast to +3.5% from +3.3%.
Early indications for the key initial round of November economic data out in a couple of weeks were generally positive. Results of the Empire State and Philly Fed surveys were mixed, with the former declining to 49.2 from 49.9 on an ISM-comparable weighted average basis, while the latter rose to 53.0 from 51.5. And our MSBCI survey (see US Economics: Business Conditions: Headline Hovers as Components Strengthen by Dane Vrabac, November 15, 2011) showed some improvement. Our initial ISM forecast is for a slight increase in November to 51.0. Meanwhile, jobless claims have continued to gradually trend lower, with the 4-week average of initial claims reaching the lowest level since April in the survey week for the November employment report after a 7,000 decline from the October survey week. Our initial forecast for November non-farm payrolls is +120,000, in line with average growth seen over the prior three months.
Trading is likely to be very thin in the coming week. Thanksgiving is usually the slowest week of the year in US markets, with the Thursday holiday, minimal attendance Friday (which will have an early bond market close for the few people actually at work), and generally light trading in the first part of the week as well. This could lead to some exaggerated moves in response to important developments regarding the super committee or in Europe. On top of any developments in these key areas, an unusually active calendar of Fed and Treasury supply from Monday to Wednesday in the expected thin markets has dealers wary. On Monday, the Fed will sell $8-8.75 billion in the 3- to 8-month maturity range, then the Treasury will auction $35 billion 2-year notes, then the Fed will sell $8-8.75 billion in the 2 1/2 to 3-year maturity range in the afternoon after the 2-year auction. On Tuesday, the Fed will buy $4.25-5 billion of November 2017 to November 2019 maturities, followed by a $35 billion 5-year auction by the Treasury, followed by $2.25-2.75 billion of Fed buying in the November 2036 to August 2041 sector. That will be it for the Fed for the week, but Treasury will be back Wednesday with a $29 billion 7-year auction. The economic data calendar is pretty quiet and unlikely to be significantly market-moving. Notable releases include existing home sales Monday, revised GDP Tuesday, and durable goods and personal income Wednesday:
* We look for existing home sales to decline to a 4.80 million unit annual rate in October. The pending home sales index ticked lower in September, pointing to some slippage in resale activity. Results from some regional realtor associations have also looked a bit softer, with the California Association of Realtors saying that the decline in conforming loan limits had a "cooling effect" on sales. So, we look for about a 2% decline in October sales on a sequential basis. Although the latest dip in mortgage rates has led to a further improvement in affordability, tightened lending standards and poor buyer psychology continue to represent significant headwinds.
* We expect 3Q GDP growth to be revised down to +2.2% from +2.5%, with sizeable - but partially offsetting - revisions to inventories (down) and net exports (up).
* We forecast a 1.2% decline in October durable goods orders. Company reports point to some further slippage in the volatile aircraft category following a very steep drop in September. Meanwhile, the key core component - non-defense capital goods excluding aircraft - is expected to show a modest 0.5% decline, as the impact of seasonal distortions, which have tended to depress readings in the first month of the calendar quarter followed by gains in the next two months, more than outweigh the fundamental improvement signaled by the latest ISM survey.
* We look for a 0.2% gain in personal income in October and a 0.3% rise in spending. The employment report pointed to a modest uptick in income growth. Meanwhile, unit sales of motor vehicles edged up only slightly in October, but retail control in the retail sales report was surprisingly strong, pointing to a solid rise in consumer spending, especially in real terms. Our translation of the CPI data points to a 0.1% decline in the headline PCE price index along with a mild 0.05% rise in the core, which should leave the year-on-year core rate steady at +1.6%.
Summary and ConclusionsThe newly appointed Monti government will have its hands full in a difficult economic and market environment. While the limits of debt sustainability have not been reached yet, in our view, confidence is a crucial element to prevent any self-fulfilling prophecy, such as a buyers' strike, from materialising. More political stability definitely helps, as well as an often overlooked strength and size of the balance sheet of the household sector. We look at all these issues from several perspectives:
· With household net wealth at around €8.7 trillion - the highest in the G7 world relative to household disposable income - the Italians stand out. Financial assets are €3.6 trillion, while real assets account for the rest.
· Yet, while not particularly so relative to other advanced economies, net wealth is also fairly concentrated, with the share of the wealthiest 10% of households at 44.5%; the poorest 50% owns 9.8% of the total.
· Government bonds, at €355 billion (€195 billion of which are Italian bonds), account for 10% of the total. But they are not actual wealth, since they will have to be paid off by future taxes. What looks like an asset is also a liability.
· A wealth tax might well contribute to a sense of fairness, given the likely substantial sacrifices that low-income Italian households will have to endure. But, at most, it could put a few billions in the state coffers.
· Asset sales might help boost revenues too, and Italy appears to have substantial margin for manoeuvre on this front. And cutting the tax wedge while raising VAT is another fiscal/structural reform that might produce benefits.
· Yet, to bring down the debt burden and boost confidence, substantial primary balances and faster growth are likely to be the crucial ingredients. Italy has a strong record of delivering the former, but not the latter.
Wealth in Italy - How Much?
What €8.7 Trillion Net Wealth Is Made ofThe gross wealth of Italian households, we estimate, is €9.5 trillion, while their net wealth is €8.7 trillion. Real assets - such as housing, non-residential buildings, valuables, durable goods, plants, machinery, equipment, inventory and goodwill - account for approximately two-thirds of gross wealth, or about €5.9 trillion. Financial assets amount to €3.6 trillion; financial liabilities to €840 billion, or about 8.8% of total assets.
The aggregate wealth number corresponds to about €340,000 per household. Since the beginning of the financial crisis in 2007 and subsequent economic fallout, this has declined by about 6% at current prices, or 13% at 2009 prices. Naturally, wealth is not equally distributed - quite the contrary. According to Bank of Italy data, the share of the wealthiest 10% of households is 44.5%; the poorest 50% owns 9.8% of the total; those with negative net wealth are 3.2%.
Another helpful indicator on the distribution of wealth - and of anything else - is the Gini index or coefficient, which ranges from 0 = minimum inequality to 1 = maximum inequality. Bank of Italy calculations put this index at 0.61 in Italy, slightly down from 0.63 a decade earlier. By contrast, household income is more equally distributed than net wealth, with the Gini index equal to 0.35.
Cross-country comparisons, based on OECD data, are rather imprecise, for three reasons. First, definitions are different: with the exception of Italy, data refer to the entire set of households including social private institutions; for the US, the data do not include unlisted companies and sole proprietorships, but do include social private institutions; for Canada, Germany and the US, real assets include durable goods. Second, calculations are different: for example, the OECD ratio of real assets to disposable income for Italy differs from that calculated by the Bank of Italy because the former is estimated using a different methodology and dataset. Third, timeliness is different: Bank of Italy data are more updated and cover the period 2009-10; OECD data are for 2008-09.
With these limitations in mind, it looks like Italian household wealth, as a share of disposable income, is the highest across the G7. Italians' real non-financial wealth is about six times disposable income, higher than in the other countries surveyed. Italians seem to show a greater propensity to invest in real estate, perhaps because of the large number of small family firms, we think, for which buildings also represent business capital. This part, of course, should not be taxed.
What's more, Italian households' financial assets are more than three times their disposable income; this is lower than in Japan, the UK and the US - perhaps because the relatively small size of the public pension system in the English-speaking countries implies larger investment in insurance technical reserves - but higher than in Germany and France. Italian households' financial liabilities, at 88% of disposable income, are the lowest in the G7.
A Deep-Dive into Households' Assets and LiabilitiesAn in-depth analysis of the breakdown of Italians' financial assets shows that currency, transferable and other deposits - along with insurance technical reserves - represent the lion's share, followed by shares and other equity. Bank bonds account for 10% of the total.
Government bonds, with a value of up to €355 billion (€195 billion of which are Italian bonds), account for 10% of the total; relative to the previous quarter, holdings of government bonds have increased by 5.2% (relative to the corresponding quarter of the previous year, the increase is 2.2%). Households' liabilities are dominated by loans, mainly mortgages for house purchase, representing nearly 90% of that total. The share of other accounts payable is approximately 10%. Insurance technical reserves represent less than 5%. Relative to the previous quarter, liabilities have increased by 1.5% (relative to the corresponding quarter of the previous year, the increase is 3.6%).
Unlike financial assets and liabilities, which are reported on a quarterly basis (but with a time lag of around 100 days relative to the quarter they refer to), value and composition of real assets are estimated once a year by the Bank of Italy. Perhaps unsurprisingly, given the modest drop in house prices (which are the key input for our estimation work), housing wealth - by far the most important component of households' real assets, with dwellings accounting for over 80% of the total - seems to have diminished recently.
According to data from the Italian Ministry of Economy and Finance, households use about two-thirds of their dwellings as their main home; approximately 14.7% is classified as an extra property (e.g., second home); 8.6% is to let out. The 10% or so remaining is split among other uses, rent-free or no classification.
The remaining one-fifth or so of real assets, which is subject to more estimation uncertainty due to lack of timely information on overall amounts and detailed breakdowns, is dominated by non-residential buildings (6% of the total), plant, machinery, equipment, inventories and goodwill (6%), land (4%) and valuables (2%).
Is Government Debt Net Wealth?A note of caution is that, as the famous economist Robert Barro argued in the mid-1970s, government bonds are a special kind of net wealth - if at all. The basic argument is that government bonds are not actual wealth, since they will have to be paid off by future taxes. Put differently, what looks like an asset is in fact also a liability of equal value. So the €195 billion of Italian government bonds should be netted out from net wealth.
Economists call this principle Ricardian equivalence, because core economic theory suggests that consumers internalise the government's budget constraint, so the timing of any tax change does not affect their change in spending. Thus, it doesn't matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same. So, the chances are that government bonds are treated as net wealth only because of some kind of psychological mechanism: government debt is here today, while future tax hikes to pay it down are perceived to be in a distant future.
On the Issue of Introducing a Wealth TaxA number of commentators, at times, argue that a wealth tax could perhaps help improve the public finances. Some also think that it might contribute to a sense of fairness and make painful structural and fiscal reforms easier to digest - if the adjustment, which inevitably tends to affect to a greater extent those living on low incomes, is shared with the wealthy part of the population. Whether a wealth tax is opportune on these grounds - or opportune at all - is a decision that we're happy to leave to the politicians. Here we just make three points on what amount of revenue could potentially be raised.
First, while the stock of household wealth is quite high, the flow of household income is not particularly high. For example, we estimate Italian GDP per capita in 2012 at around €26,000. This means that it's not necessarily true that households owning, say, two properties could pay vast amounts of money upfront. So, from a policy-making standpoint, one would have to establish whether it's more effective to attempt taxing the stock of wealth as a one-off measure for a few years, or taxing smaller amounts on an ongoing basis. For example, re-introducing the municipal property tax (ICI) on owner-occupied dwellings might raise about €3.5 billion per year, according to calculations by the Italian Ministry of Economy and Finance.
Second, while not particularly concentrated relative to other developed economies, the fact is that the richest 10% of households own around 40% of total wealth, or approximately €3.5 trillion. Presumably, this is the stock that could be taxed more easily, given that the ‘capacity to pay' of low-income earners is rather limited, in our view. How much could be raised? In Spain, a wealth tax raised about €2 billion when it was last collected from 967,793 people in 2007. In France, the impôt de solidarité sur la fortune raises about €4 billion per year. This is calculated by paying a rate of 0.55% for net taxable wealth between €800,000 and €1.31 million, which gradually increases up to 1.8% for net taxable wealth higher than €16.79 million. In Italy - just for illustrative purposes - even if the maximum rate were applied to the wealthiest 10%, revenue would amount to around €6 billion. If the total stock of wealth were taxed, we calculate that revenue would amount to around €15 billion. So, at most, a wealth tax could put a few billions (possibly as much as a very low double-digit figure) in the state coffers.
Third, while there are many variations that could be applied to the simple illustrative example above and that could change the overall results, the chances are that, say, €15 billion is likely to be a decent back-of-the-envelope estimate for an upper bound. Clearly, in any country where the so-called shadow economy, i.e., activities where taxes are not withheld and paid, represents a fair share of the pie, households have usually found means to avoid the taxman. We believe that the shadow economy accounts for a large share of the pie in Italy - about one-fifth of the total. What's more, estimates by Bank of Italy's economists suggest that under-reported assets held abroad by Italians could range from €124 billion to €194 billion, i.e., between 7.9% and 12.4% of GDP. The latest tax shield resulted in €60 billion of previously undeclared financial assets (shares, mutual funds and debt securities), representing between 30% and 48% of the total undeclared. And the upper boundary of deposits held abroad is estimated at around €50 billion. Capital controls don't exist in the EU. So, capital flights could be one side-effect of a wealth tax. Any effort to fight tax evasion would naturally help to limit this side effect, but perhaps not prevent it from happening altogether.
Growth - The Missing IngredientItaly is suffering from chronically low economic growth. In particular, potential growth has steadily declined from approximately 4% in the 1970s to less than 1.5% before the crisis. In addition, since 2001, Italy has stumbled from recession to recession and has virtually stagnated.
What's more, not only has Italy underperformed its own post-war norm, it has expanded far lower than the - not too impressive - eurozone average of 1.1% over the period 2001-10 (see Assessing the Damage, October 26, 2009).
How Italy Compares to its Peers in the EMUItaly's disappointing growth record seems to reflect tightly regulated product markets, as well as a complex and slow legal and judiciary system, which makes it difficult to conduct business efficiently. Inefficient bureaucracy is a problem too, e.g., Italy has the highest average payment duration for the public sector. Moreover, perhaps unsurprisingly, the average payment delay seems to have increased during 2009-10. While other southern European countries are not far behind, it seems that the public sector is particularly slow and inefficient in Italy.
Our country comparisons across many dimensions show that Italy scores better than only the small EMU peripherals (see Country Scoring in a Monetary Union, October 13, 2011). What's more, Italy is the third most vulnerable country from a structural standpoint, as shown by our Structural Features Score, which is one of the several categories of our ranking tool that compares eurozone members across measures of economic affluence, demographic trends, trade openness, price and non-price competitiveness, and business regulations (and their enforcement) and administrative burdens.
This is not to say that Italy has not implemented important reforms. After all, the two so-called ‘Bersani laws' (named after the minister who introduced these new norms) helped remove obstacles to competition in retail trade and professional services, among others. However, this is clearly not enough to bolster growth. Extending the scope of liberalisation to raise productivity and growth needs to continue. According to the OECD, completing the liberalisation process could increase GDP per capita by 2.5%. Regrettably, a third ‘Bersani law' never saw the light, and the services sector is still too sheltered from competition.
Apart from labour productivity, the other driver of potential growth is the labour force. At 8.3%, Italy's unemployment rate is some 2pp lower than the eurozone average. Yet, total employment as a share of the working age population is one of the lowest. And low female participation in the workforce, as well as high youth and long-term unemployment, stands out compared to most EMU countries. This is another factor that has held back economic growth for quite a while. Incidentally, low participation in the workforce, along with poor demographic prospects, is what makes Italy's pension system still quite expensive, despite many important pension reforms that are likely to decrease its cost over the longer term (the Stability Law raised the minimum pension age to 67 from 2026).
For the pie to grow bigger, more slices of the same size are needed (i.e., boosting participation in the labour force); or the same number of bigger slices (i.e., boosting productivity). Possibly, one would want to see both. At this stage, the combination of these factors is such that Italy's potential pace of expansion over the next several years - without structural reforms - is probably slightly less than 1%, one of the lowest growth rates in the advanced world.
What's the Impact of Structural Reforms?Several econometric studies suggest that Italy's potential growth rate could be raised, to various degrees depending on the mix of measures, if structural reforms were implemented.
Analyses on various countries/regions show that product market reforms, such as cutting the price mark-up, increasing domestic competition, reducing state ownership and administrative burdens, have beneficial effects on GDP growth, productivity and job creation - especially in the longer term. Cutting the price mark-up seems to be the most promising area in terms of potential benefits for growth.
Similarly, labour market reforms, such as reducing the tax wedge or shifting the tax burden from labour to VAT, and deregulating various aspects of job relations would boost output and employment. Reducing the tax wedge or shifting the tax burden from labour to VAT seem to be the most promising areas in terms of potential benefits for growth.
The upshot is that there's no shortage of things to do in Italy. Any beneficial effect from the structural reforms will likely materialise over a long timeframe. But with the newly appointed Monti government just starting to work, even just starting to implement any of the above would be key to boosting confidence in the near term and Italy's economic fundamentals further down the line.
What's more, in the hypothetical scenario of some form of external support (ECB continuing to buy Italian bonds in the secondary market, EFSF precautionary programme, IMF credit line, etc.) the fact that Italy does its homework makes it easier for such support from core Europe to materialise - if needed.
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