The Euro, Demography and Italys Long Term Growth Challenge Edward Hugh - Cortona, September 2011 (Revised and Updated)
Summary Points• The most recent crisis was not an arbitrary phenomenon• It was not simply a question of stupid and irresponsible financial products• There are underlying macroeconomic and social process we need to understand• The worst of the first stage of the crisis may be over, but we could now be entering a new and more dangerous phase• The Euro itself forms part of the backdrop to the crisis• As do long term changes in Europe’s demographic profile• The greatest challenge facing any future Italian government ishow to maintain welfare commitments in the face of populationageing given the level of accumulated debt.
Italy• Italy’s principal problem is long term low growth, not excessive interest costs• High accumulated government debt is a symptom of the problem not the cause• Italy’s problems are partly institutional and partly demographic, both problems need addressing• Median population age is an important economic indicator• Populations with high median ages tend to be export dependent• Export dependency gives a better, more precise measure of international competitiveness.• An export dependent country is internationally competitive when it has a large enough export sector to drive economic growth.• Italy will soon need to accept the proposed EU bond purchasing programme• If Italy’s growth problem is not adequately addressed there is a high risk that the country’s gross government debt level can spiral upwards out of control• Italy is also a high political risk country. It is the only country on Europe’s periphery where there are politicians who talk openly about Euro exit as an option.
Italy Suffers From Low Growth ………… And An Ongoing Current Account Deficit Italy’s average annual growth rate has fallen steadily in recent decades. The rate for 2001 – 2010 was about 0.6% and it is not excluded that during 2011 – 2020 it will be negative.And the growth rate hasdropped as the currentaccount deficit has widened.There is an obviousconnection – internationalcompetitiveness.
Double Dip Recession Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009.After an 18 month recovery, the economyagain fell into a second “double dip”recession in September 2011, after asurge in borrowing costs forced thegovernment to apply stringent austeritycuts in an attempt to recover investorconfidence.
Sharp Economic ContractionThus the Italian economy continues to demonstrate its long term underlyingweakness characterised by short recoveries followed by longer than averagerecessions. It is now widely expected to contract by around 2% in 2012, and then byanother 1% in 2013. It could then grow moderately in 2014 – perhaps by 0.5% - butwhy should we expect the country not to fall back into recession again in 2016?
Living Standards In Long Term DeclineAfter years of being stationary Italy’spopulation has risen sharply over the lastdecade – from around 57 to just over 61million - but GDP hasn’t changed. Theresult has been a large fall in GDP percapita. This fall has been in absolute terms, but in relative terms the change is also clear. Germany’s relative position fell steadily in the 1990s, then stabilised, and has even improved since the crisis. Italy’s fell slowly in the 1990s, then, since the turn of the century, the rate of decline has accelerated.
The outlook is not appetising As the population ages domestic demand moves into long term secular decline. Retail sales, for example, are now around 94% of the 2005 level. And as public debt is paid down, government consumption will simply get less and less.
Italy Didn’t Have A Housing Boom Pre 2008......... Yet Construction Continues To Decline This trend is not likely to change. The winter 2011 Monti measures involved a substantial rise in property related taxes, implying lower property values in the future. In addition Italy’s demographics are not favourable to housing booms.
So Now It Is All About ExportsGDP = Household Consumption + Investment + GovernmentConsumption+ Net Trade (Exports – Imports)Now if household and government consumption are fallingsystematically, the only factor which can give a direct boost to GDP is therelative movement in exports and imports. Positive movement here canstimulate investment in the export (or tradeable) sector as expectationsbuild for increased demand.Total Investment = Investment for Exports + Investment For DomesticDemand.
Just Not Sufficiently Competitive? While Italian exports surged back after the financial crisis recession they never in fact attained their pre- crisis level, and now they are once more declining again. In addition, even though Italy’s goods trade deficit has reduced substantially over the last 12 months, it is still a DEFICIT.As we can see in the chart on theright, the Italian economy was on anunsustainable path from the end of2009 to mid 2011, as excessivegovernment spending fed an importsurge. As government spending wascut this import boom burst, anddomestic demand collapsed, takingthe country deep into recession.
How To Define Competitiveness? The issue of competitiveness has become one generating more heat than light in debate during the current crisis. The validity of one commonplace measure (REERs) widely used historically has been repeatedly questioned. In my opinion such questioning has been largely motivated by ideological and political motives in contrast to scientific ones. In fact the evidence is clear enough.The REER (or Relative price and cost indicators) aim to assess a countrys (or currency areas)price or cost competitiveness relative to its principal competitors in international markets.Changes in cost and price competitiveness depend not only on exchange rate movements butalso on cost and price trends. The specific REER for the Sustainable Development Indicatorsis deflated by nominal unit labour costs (total economy) against a panel of 36 countries (=EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, NewZealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculateREERs, reflecting not only competition in the home markets of the various competitors, butalso competition in export markets elsewhere. A rise in the index means a loss ofcompetitiveness. (Eurostat Definition)
Output & Productivity High output per worker and high wages are perfectly compatible. The road to achieve this win-win combination is through raising productivity, thus maintaining unit labour costs constant, or even reducing them.As can be seen from the accompanying charts,Germany achieved this combination between 2000and 2008, while Italy didn’t. In Italy productivitystayed pretty much constant while unit labourcosts rose, meaning salaries rose without theaccompanying productivity, while in Germanyunit labour costs stayed constant whileproductivity rose. This also gived the lie to the“cheap German wages” argument, since if wageshadn’t risen then ULCs would have fallen, whichthey only did briefly between 2006 and 2008.
The problem in part is that value added is often a sectorial issue. For example agriculture and construction have historically been low value added and often high unit labour cost sectors, whereas petrochemicals or biotechnology are high value added but also often low ULC sectors, despite the fact that wages are higher.Naturally most societies would like to have a large proportion of high value added activities, anda comparatively small proportion of low value added ones. But this isn’t as straightforward as itseems, since the transition from agriculture to biotechnology doesn’t move along what we couldcall a smooth production function. Namely you can’t simply transfer workers from one section tothe other. It ain’t that easy. The large number of construction workers recently displaced in Spaincan’t simply move into machine tool manufacturing, for example. A countries ability to engage in what are high value activities at any moment in time depends onkey factors like the skill, education and experience levels of the workforce, and these changeonly slowly. Critically the distribution of these factors depends to some extent on the agestructure of the population.
But in part the level of unit labour costs depends on the level of international competitiveness, which in part depends how much of the economy is in the tradeable sector and how much in the non-tradeable part of the economy. By tradeable we mean in competition with other producers or service providers beyond the national frontier.The key mechanism assumed here is that the tradeable sector, being exposed to externalcompetition, by definition needs to be more competitive to survive.So a measure of a country’s lack of international competitiveness isn’t only that exportsare too small, it is also that imports are too big, which is another way of saying that thedomestic tradeable sector isn’t big enough. Normally this loss of competitiveness isassociated with a growing trade and current account deficit, which means the process ofnon productivity supported rising living standards can only continue as long as someexternal agent is willing to finance it. When confidence that the process is sustainablesubsides, people cease financing, and a crisis occurs. This is what happened to Italy in thesummer of 2011.
Export Dependency and International CompetitivenessBut now I would like to introduce an additional concept which is generally not acceptedin mainstream economic theory, the idea of export dependent economies. Basically theidea is that as populations age, demand for credit and with it the rate of increase indomestic demand wanes. As can be seen in the chart on the right below, householdconsumption in Italy surged in the 1990s, and the rate of growth in consumer demandwas quite rapid. The consumer boom was also linked to Italy’s last housing boom. Thenbetween 2000 and 2007 something changed, and the growth rate slowed. Any internallycoherent macro economic theory needs to be able to explain this change. Then followingthe global crisis household consumption slumped, recovered slightly and then slumpedagain.So if we go back briefly to the earlierchart on the composition of GDP, wecan perhaps formulate a new andbetter definition of internationalcompetitiveness, which would behaving an export sector which islarge enough and growingdynamically enough to produce GDPgrowth in an environment whereconsumer demand weakens aspopulations age.
The Demographics Of Export Dependency As populations age beyond a certain point economies transit from being consumption driven to being export driven. Thus the process is not random or arbitrary, but follows a path which is, in principle, identifiable. This is not a question of choosing between options or “growth models”. There is not a choice here, since there are deep underlying structural dynamics at work, and these dynamics seem to be intimately associated with the dynamics of the demographic transition.The process is observable mostclearly in those countries with thehighest median ages attained byhuman populations to date – Japan,Germany and Italy. All three havemedian population ages of around45. Hence one explanation for Italy’slow growth rate and highgovernment debt is based on thefact that Italy still runs a tradedeficit. .
Population Ageing – A Unique Historical ChallengeWe live in a world of rapidly ageing populations, not just in the economicallydeveloped societies, but in many emerging nations too. Due to the one child perfamily policy China will be one of the fastest ageing societies on the planet in the2020s. The economic and social implications of such a global ageing process arebound to be profound. Two points stand out:• the process is seemingly irreversible.• No other single force is likely to shape the future of national economic health,public finances, and policymaking over the coming decades.Strangely, this issue receives only a fraction of the attention that has been devotedto global climate change, even though, arguably, ageing is a problem our social andpolitical systems are, in principle, much better equipped to deal with.In particular it would be interesting to discover why so many mainstreameconomists seem oblivious to the problem despite the fact that the developedworld sovereign debt crisis seems so self evidently associated with thephenomenon.
Life Cycle Effects – Franco ModiglianiModigliani’s life cycle hypothesis suggests that a population’saggregate financial behaviour - just like that of an individual -changes depending on age.Children are dependents, and hence net dis-savers for their families, which is why somany high fertility societies have such low savings rates. The secret to raising theaggregate saving rate is having less children.In terms of a person’s adult life, those in their twenties and early thirties tend to benet borrowers as they are relatively low earners at the same time as they look toestablish a family, buy housing, educate children etc. Societies with many people inthis age group tend to see rapid credit growth.At some point around middle-age the person then tends to move from being a netborrowers to becoming a net investor at just the time they enter their economicprime and accumulate financial assets to fund their retirement.After retirement people tend to maintain their living standard by gradually sheddingthe financial assets they’ve been accumulating to fund their nonworking days. Thisprocess is not uniform, and older people generally tend to consume less and conservetheir savings.
So Could Something As Simple As Movements in Median Population Age Help Us Understand How Economies Evolve? Ours is an age of rapidly ageing societies, but not all societies are ageing at the same rate. The United States for example is still a comparatively young society. Indeed even in 2020 will still be younger than Japan was in 2000. Near replacement fertility and constant immigration have been the main factors behind the relative youth of USSocieties are in some kind of homeostatic “bad society.equilibrium” when they have fertility levels offive children plus per female. As fertility fallssocieties develop economically, and start to agethrough population structure impacts. What isso modern about our current situation is not theageing itself, which started in Europe with theindustrial revolution, but its velocity, its globalextension, and the high median ages now beingattained in some developed countries. Japan’s economy is completely export dependent. In the US consumer demand is still an important component in economic growth.
As far as we are able to understand the issue at thispoint, population ageing will have major economicimpacts and these can be categorised under four mainheadings:i) ageing will affect the size of the working age population, andwith this the level of trend economic growth in one country afteranotherii) ageing will affect patterns of national saving and borrowing, andwith these the directions and magnitudes of global capital flows iii) through the saving and borrowing path the process caninfluence values of key assets like housing and equities iv) through changes in the dependency ratio, ageing will influencepressure on global sovereign debt, producing significant changes inranking as between developed and emerging economies.
While population ageing is universal the short term impact willbe much more localised. The pace of aging varies greatly acrosscountries and regions.The effects of the process are expected to be most pronounced inthose countries that remained complacent in the face of severaldecades of ultra-low fertility rates (total fertility rates of 1.5 andunder), which in effect means Japan, China, South Korea, theGerman speaking countries and much of Southern and EasternEurope.
Another way of looking at these demographic changes is in terms of thedependency ratio, which can be defined in a number of different waysdepending on the problem being addressed. For present purposes whatmatters is the old age dependency ratio.Less developed economies tend to have high youth dependency ratios, andas a result low savings rates. In mature economies the situation inverts –there is a high and growing elderly dependency ratio, and demand forprivate credit is weaker.Those societies that are ageing morerapidly have higher elderlydependency ratios, and theproportion of over 65s is growingrapidly. The demand for pensionsand health care puts increasingpressure on state finances, so thedemand for public sector credit rises.Public debt is high – in Japan grossdebt is now around 225% of GDP, inItaly it is 120% and in Germany 85%.
In some cases not only will population age, it will alsofall. In Germany total population is expected to fall from its currentlevel of 82 million reaching anything between 69 and 74 million by 2050,depending on the future course of life expectancy, immigration and fertility.And the proportion of people aged 65 and older is projected to rise from justunder 20% today to just over 33% by 2050. At the same time, the number ofvery elderly (those aged 80 and over) will nearly triple to as much as 15% ofthe total population.
In Italy population is projected to remain more or less stationary, ataround 60 million, at least until the 2030s, but the age structure of thepopulation will be constantly shifting. (Data: UN 2008 forecasts, median estimate)
One Key Shift Occured In The 1970s. This Was The Point Where Each Generation Started To Get Smaller Than Previous OneAnother Key Decade Comes In The 2020s. As the largest Population Cohorts ReachRetirement AgeThe Elderly Dependency Ratio Rises Substantially
As the number of children per family drops health improves and young people are better educated As a result societies get richer much more quickly From Demographic Very Young Societies To Transition Very Old Ones Societies with very high median ages are likely to haveSocieties with large numbers of people problems with innovation and creativity, and this issue isbetween 35 and 50 are highly productive made worse if low growth leads highly educated young people to leave.
All of which has to be reasonably obvious once you have gotten the basic idea. Even the IMF seems Few seem to have noticedThe curious issue is why to have failed to that the world has somehowso few mainsteam notice that changed since 2007. Most areeconomists and policy something “fishy” is simply waiting for things tomakers have “gotten it”. going on. magically “get back to normal”. Could it be that academic economists are simply blinded by the mathematical sophistication of those very models they thought would convert their discipline into a science?
Is Italy Like Venice Sinking Steadily Into the Sea?Italy’s famous “leaningtower” has held uprightfor nearly a thousandyears. It is unlikely wewill be able to say thesame about the country’sunstable populationpyramid.Ageing is irreversible. But it is possible to age more slowly. It is also possible, as a society,to age less painfully by stabilising the population pyramid and by rising the economicgrowth rate to fund welfare costs. Italy needs economic and demographic stability andsustainability.
Italian Fertility Has Fallen To and Remained Around 2/3 Replacement LevelPopulation Has Recently Grown Rapidly, But Only As A Result Of Immigration
There Was A Significant Increase In The Italian Workforce And – Before TheCrisis – In EmploymentBut Due To The Poor Productivity Performance And The Strength Of The InformalEconomy This Did Not Translate Into Increased Economic Growth
Italy’s problem obviously isn’t only demographic. If anything Italy’s demography has improvedslightly over the last decade even while the economic situation has deteriorated. In part this is theresult of a changed external environment. But there is obviously lots Italy could do to improve thesituation. Especially as regards the quality of its institutions.
Italy and The Eurozone Debt Crisis Total Italian Debt Is Not Excessive In Comparison With Some Other Countries in The Eurozone, But Public Debt Is The Second Highest.Despite Normally Having Had Primary Balances Italy Has Run General Budget Deficits since The 1980s In Part The Problem Is The Weight of the Debt, The Burden of Interest Payments
Italy Is Now Poised On A Knife Edge Key Factors: • Growth • Inflation • Interest ChargesHence The Problem Of MarketPressure, And Interest Rates.The IMF currently predicts thatGross Government Debt To GDPwill peak at 124% in 2013. Anyslippage on this and debtrestructuring becomes inevitable.Investors Are Worried. Market As of June, Italian banks had borrowed more thanResponses are not just simple 283 billion euros from the ECBand part of which wasspeculation. ECB support is critical, invested in high yield government bonds. Banksbut so are radical measures to increased their holdings of Italian bonds by aboutincrease the growth rate. 78 billion euros in the first half of 2012.
Italy’s Recession Deepens Italy shrank further into recession in the second quarter with a 2.5 per cent annual decline. The 0.7 per cent quarterly fall in gross domestic product, only slightly better than the first quarter’s 0.8 per cent decline, means the economy has now been contracting for over a yearAnd there is at least another year ofthe same or worse to come asspending cuts steadily bite and theEuro debt crisis rocks its way forward.The recession will weaken taxrevenues and hit jobs and consumerspending, a vicious circle which makesit harder for Mario Monti, who isaiming to cut the budget deficit to 0.1per cent of GDP in 2014, to meet hispublic finance goals.
Hard Times AheadConsumer Confidence and PMIindicators suggest that the Italiangovernment’s GDP growth estimates(of a contraction of 1.2% for 2012 andan expansion of 0.5% for 2013) areway too optimistic . The employersgroup Confindustria now forecast acontraction in GDP of 2.5% in 2012. Afurther fall of 2.0% is not unlikely asthe European debt crisis worsens.Compared to the other forecasters Iwould be more negative on theoutlook for both private consumptionand investment activity. With a morenegative outlook for the euro areaeconomy – destination for 43% ofItalian exports — these are unlikelyto put in an unexpected stellarperformance.
Unemployment Rising Sharply Italys unemployment rate hit a record 10.8 percent in June, up from 10.6 percent in May. There were 2.79 million people looking for work in June, according to seasonally adjusted figures -- a rise of 37.5 percent compared to a year earlier. Youth unemployment dropped from 35.3 percent in May to 34.3 percent. These are not yet Spanish numbers, but they are not to be sneezed at eitherThe number of people living inabsolute poverty in Italy rose to 3.4million in 2011, or 5.7 percent of thepopulation, up from 5.2 percent in2010.Those living in relative povertyfor Italian standards were roughlystable at 8.2 million, or 13.6 percent.But among families with no workersand no pensioners, the relativepoverty rate rose to 51 percent from40 percent.
Fiscal Targets Look Increasingly Out Of Reach The implementation of austerity measures in Italy is likely to have a substantialnegative impact on the economy in the coming years. Given its lack ofcompetitiveness, the economy lived off constant demand stimulus from thegovernment. Without this the growth problem is likely to become worse.There have now been five fiscal packages since July 2011, aimed at a cumulative fiscalconsolidation of 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With themajority of the measures concentrated in 2012, there will inevitably be a largenegative impact on the economy throughout this year. Given the deep recession thecountry will be in over the next couple of years and poor potential growth prospectsover the medium- and longer-term, Italy’s public sector balance sheet problems arelikely to mount.Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison withmany Euro Area countries the governments projection of a close-to-balanced budgetin 2014 looks hugely optimistic. A more realistic expectation would be for the deficitto be under the EU 3% level at that stage, but the danger is this could well mean grossdebt to GDP will be over 130%. Above the danger mark.
The ECB report produced criticism from the Italian consumers’ association Codacons, who complained that the ECB itself had not found a solution to this situation. “If companies are insolvent it’s because banks are strangling them, denying them credit,” Codacons said. Coldiretti, the Italian agricultural association, estimates that 60 per cent of companies in the sector risk being starvedThis problem is more complex than it of credit as they face interest rates thatseems. It is not so much a question of are 30 per cent higher than the average ofcredit being strangled, but of demand other sectors.being strangled as austerity bites.Companies who cannot sell profitablyare a high credit risk. There is demandglobally, but as I am saying Italy isinsufficiently competitive to takeadvantage of it. The high cost offinancing Italian government bonds ispushing up longer term interest rates,and discouraging investment, and this isan issue the ECB could address.
The Euro Area’s Single Financial Market UnwindingItalian banks have borrowed more than 283 billion euros from the ECB via the 3year LTROs and use the liquidity obtained to buy government bonds which paymuch higher yields. This helps bank profitability and enables them to recapitalise,but at the cost of reducing private sector credit. This is where the real “crowdingout” comes.Banks increased their holdings of the country’s bonds by about 78 billion euros inthe first six months of 2011. This forms part of the “nationalisation” of Europe’ssovereign debt markets. Foreign investors cut their holdings of Italian governmentsecurities by 18 percent in March from a year earlier, according to the Bank of Italy.In the same month Italian banks boosted them by 39 percent.
The possible Italian bailout isEasing In The Bailout becoming a tricky political issue. The technocratic government of Mario Monti would like to get an MoU agreed before handing the country back to the politicians. The request for bond buying would involve ECB secondary market purchases.But the ECB has made clear what it thinks is required. Countries with high unemploymentneed to “abolish wage indexation, relax job protection and cut minimum wages”, the banksaid in its August monthly bulletin. The bank is not impressed with the Italian labourreform, which is too little too late, and thinks direct wage cuts are now the only remedy.Unsurprisingly, many in Italy arebecoming reticent about handing overtheir country’s future to an institutionwith such views, and pressure ismounting for Monti not to ask forhelp. That having been said, thecountry really has no alternative if itwants to stay in the Euro.
Is Italy Facing A period of Growing Political Instability? The “if Italy wants to say in the Euro” bit should not be taken lightly. Mario Monti warned recently that excessive pressures on the struggling countries was threatening the future of the Euro."I can assure you that if the (bond yield) spread in Italy remains at these levels for some time then you aregoing to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he saidon a recent visit to Helsinki.He was, of course, referring to theambivalence of Silvio Berlusconi onthe Euro issue, and the outrighthostility to the common currencydisplayed by the rising (5) star ofItalian politics, Beppe Grillio. “Afterme the populists”, as Monti once said.
Dangers of Sovereign Debt Default?According to a recent Standard & Poors report, the timing of thecurrent debt crisis is not a coincidence since cost of caring for thegrowing numbers of dependent elderly will both affect growthprospects and dominate public finance policy debates across theglobe, and for many years to come.Even if most governments have long been aware of the need toprepare for the looming problem, the rapid build-up ofgovernment debt over the past three years has effectivelyheightened the need to do more to advance reforms aimed atcontaining the risks to sovereign budgets, especially incountries with high expected future increases in age-relatedspending.
A Delicate Balancing ActReasonable empirical confirmation exists that the recentsurge in global imbalances was, in part, an offshoot ofslow-moving underlying demographic determinants ofglobal capital flows.The near-term adjustments will mean more emergingmarket current account deficits and less developedmarket ones.At a global level, demographic pressures will continue toimply that the increase in desired saving will exceed theincrease in desired investment. This has one clearimplication: globally interest rates can be expected toremain low.
Longer, Healthier Working LivesIn terms of policies to address the pressures of ‘ageing’,the debate in terms of social security and healthcare oftenfocuses on raising retirement ages to reduce dependencyrates and alleviate fiscal pressures.Extending working lives relative to the time spent inretirement will not only help address the pension issue, itshould also serve to accelerate the tendency towardslarger current account surpluses across most developedeconomies, in particular in those parts of Europe whichare in the process of private sector deleveraging as part oftheir fiscal sustainability programme.
Time To Act – What Can Be Done?Short Term:- Continuing and Continuous Structural Reform• Labour Market Reform• Pension Reform• Heath System Reform• Immigration• Formalise the Informal Economy Longer Term: • Raise Fertility Rates • Global Rebalancing Initiatives • Acceptance that the Modern Growth Era – like modernity itself – doesn’t last forever.