July 12, 2006
EMU’s odd one out: Italy
Italy's government has set itself the ambitious target of coming to grips with the country's economic problems. Prime Minister Romano Prodi wants to cut payroll taxes to increase the country's competitiveness. Last Friday, Finance Minister Tommaso Padoa-Schioppa announced a plan to push the budget deficit in 2007 back below 3 percent. For the euro area, the Italian attempts to tackle the dwindling competitiveness is a highly positive development. Over the last year, the country most frequently mentioned as a candidate for leaving the European Monetary Union was Italy.
There are two reasons for this: Firstly, because it is the only EU country which had leading members of its government openly question EMU membership: the former Finance Minister Roberto Maroni called for the re-introduction of the Lira while Silvio Berlusconi tagged EMU a “disaster for Italy”. You will probably evaluate this as pre-electoral populism – and you are right, of course.
But apart from this political debate, an increasing number of scientific studies, notably by international investment banks such as Morgan Stanley, Société Générale and Deutsche Bank, have shown concern with the Italian situation in EMU. There are real economic tensions underlying this political debate.
We have been asked by the Italian journal Economia Italiana to give our assessment of Italy’s situation in EMU (summer issue 2006, forthcoming). Here is what we argue: Since the economic upswing started in 2003, EMU is subject to increasing cyclical divergences. We identify three country clusters: the stagnation-low-inflation-countries (Germany/the Netherlands), the high-growth-inflation-countries (Spain and and France) and those covering the middle-ground between the two taking the worst of both worlds. Italy, Portugal and Greece are part of this third group. They have to cope with low growth and moderate inflation, partly a result of the large burden Germany has put on their economies through a strong downward pressure on German wage growth.
We argue that these cyclical divergences do not reverse in EMU as text book models have predicted, because financial and labour markets react with lower flexibility than expected. This will be true for Italy for some time – despite reasonable efforts by the new Prodi government to push liberalisation, notably of the services sector.
The problem about prolonged boom- and bust-cycles is their permanent negative effect on economic performance. If long-term unemployment rises, qualifications deteriorate and human capital is lost. Some of the unemployed might even lose basic employment skill, pushing them permanently out of the labour force. This leads to an increase in structural unemployment. Some research even suggests that prolonged deviations from an economy’s potential output might even lead to less investment in research and development by private firms. This might help to explain the very poor Italian productivity growth in the past years.
If you are interested in more analysis on the sources and effects of prolonged boom and bust cycles, take a look at our text in: Economia Italiana Summer 2006.