A review of Italy's economic and demographic challenges, and the relation between them.

1. The Euro, Demography and Italy's Long Term Growth Challenge
Edward Hugh - Cortona, September 2011 (Revised and Updated)

2. 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 is
how to maintain welfare commitments in the face of population
ageing given the level of accumulated debt.

3. 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.

4. 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 has
dropped as the current
account deficit has widened.
There is an obvious
connection – international
competitiveness.

5. 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 economy
again fell into a second “double dip”
recession in September 2011, after a
surge in borrowing costs forced the
government to apply stringent austerity
cuts in an attempt to recover investor
confidence.

6. Sharp Economic Contraction
Thus the Italian economy continues to demonstrate its long term underlying
weakness characterised by short recoveries followed by longer than average
recessions. It is now widely expected to contract by around 2% in 2012, and then by
another 1% in 2013. It could then grow moderately in 2014 – perhaps by 0.5% - but
why should we expect the country not to fall back into recession again in 2016?

7. Living Standards In Long Term Decline
After years of being stationary Italy’s
population has risen sharply over the last
decade – from around 57 to just over 61
million - but GDP hasn’t changed. The
result has been a large fall in GDP per
capita.
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.

8. 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.

9. 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.

10. So Now It Is All About Exports
GDP = Household Consumption + Investment + Government
Consumption
+ Net Trade (Exports – Imports)
Now if household and government consumption are falling
systematically, the only factor which can give a direct boost to GDP is the
relative movement in exports and imports. Positive movement here can
stimulate investment in the export (or tradeable) sector as expectations
build for increased demand.
Total Investment = Investment for Exports + Investment For Domestic
Demand.

11. 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 the
right, the Italian economy was on an
unsustainable path from the end of
2009 to mid 2011, as excessive
government spending fed an import
surge. As government spending was
cut this import boom burst, and
domestic demand collapsed, taking
the country deep into recession.

12. 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 country's (or currency area's)
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 but
also on cost and price trends. The specific REER for the Sustainable Development Indicators
is 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, New
Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate
REERs, reflecting not only competition in the home markets of the various competitors, but
also competition in export markets elsewhere. A rise in the index means a loss of
competitiveness. (Eurostat Definition)

13. 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 2000
and 2008, while Italy didn’t. In Italy productivity
stayed pretty much constant while unit labour
costs rose, meaning salaries rose without the
accompanying productivity, while in Germany
unit labour costs stayed constant while
productivity rose. This also gived the lie to the
“cheap German wages” argument, since if wages
hadn’t risen then ULCs would have fallen, which
they only did briefly between 2006 and 2008.

14. 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, and
a comparatively small proportion of low value added ones. But this isn’t as straightforward as it
seems, since the transition from agriculture to biotechnology doesn’t move along what we could
call a smooth production function. Namely you can’t simply transfer workers from one section to
the other. It ain’t that easy. The large number of construction workers recently displaced in Spain
can’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 on
key factors like the skill, education and experience levels of the workforce, and these change
only slowly. Critically the distribution of these factors depends to some extent on the age
structure of the population.

15. 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 external
competition, by definition needs to be more competitive to survive.
So a measure of a country’s lack of international competitiveness isn’t only that exports
are too small, it is also that imports are too big, which is another way of saying that the
domestic tradeable sector isn’t big enough. Normally this loss of competitiveness is
associated with a growing trade and current account deficit, which means the process of
non productivity supported rising living standards can only continue as long as some
external agent is willing to finance it. When confidence that the process is sustainable
subsides, people cease financing, and a crisis occurs. This is what happened to Italy in the
summer of 2011.

16. Export Dependency and International Competitiveness
But now I would like to introduce an additional concept which is generally not accepted
in mainstream economic theory, the idea of export dependent economies. Basically the
idea is that as populations age, demand for credit and with it the rate of increase in
domestic demand wanes. As can be seen in the chart on the right below, household
consumption in Italy surged in the 1990s, and the rate of growth in consumer demand
was quite rapid. The consumer boom was also linked to Italy’s last housing boom. Then
between 2000 and 2007 something changed, and the growth rate slowed. Any internally
coherent macro economic theory needs to be able to explain this change. Then following
the global crisis household consumption slumped, recovered slightly and then slumped
again.
So if we go back briefly to the earlier
chart on the composition of GDP, we
can perhaps formulate a new and
better definition of international
competitiveness, which would be
having an export sector which is
large enough and growing
dynamically enough to produce GDP
growth in an environment where
consumer demand weakens as
populations age.

17. 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 most
clearly in those countries with the
highest median ages attained by
human populations to date – Japan,
Germany and Italy. All three have
median population ages of around
45. Hence one explanation for Italy’s
low growth rate and high
government debt is based on the
fact that Italy still runs a trade
deficit. .

18. Population Ageing – A Unique Historical Challenge
We live in a world of rapidly ageing populations, not just in the economically
developed societies, but in many emerging nations too. Due to the one child per
family policy China will be one of the fastest ageing societies on the planet in the
2020s. The economic and social implications of such a global ageing process are
bound 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 devoted
to global climate change, even though, arguably, ageing is a problem our social and
political systems are, in principle, much better equipped to deal with.
In particular it would be interesting to discover why so many mainstream
economists seem oblivious to the problem despite the fact that the developed
world sovereign debt crisis seems so self evidently associated with the
phenomenon.

19. Life Cycle Effects – Franco Modigliani
Modigliani’s life cycle hypothesis suggests that a population’s
aggregate 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 so
many high fertility societies have such low savings rates. The secret to raising the
aggregate saving rate is having less children.
In terms of a person’s adult life, those in their twenties and early thirties tend to be
net borrowers as they are relatively low earners at the same time as they look to
establish a family, buy housing, educate children etc. Societies with many people in
this age group tend to see rapid credit growth.
At some point around middle-age the person then tends to move from being a net
borrowers to becoming a net investor at just the time they enter their economic
prime and accumulate financial assets to fund their retirement.
After retirement people tend to maintain their living standard by gradually shedding
the financial assets they’ve been accumulating to fund their nonworking days. This
process is not uniform, and older people generally tend to consume less and conserve
their savings.

20. 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 US
Societies are in some kind of homeostatic “bad society.
equilibrium” when they have fertility levels of
five children plus per female. As fertility falls
societies develop economically, and start to age
through population structure impacts. What is
so modern about our current situation is not the
ageing itself, which started in Europe with the
industrial revolution, but its velocity, its global
extension, and the high median ages now being
attained in some developed countries.
Japan’s economy is completely export dependent. In the US consumer demand is still
an important component in economic growth.

21. As far as we are able to understand the issue at this
point, population ageing will have major economic
impacts and these can be categorised under four main
headings:
i) ageing will affect the size of the working age population, and
with this the level of trend economic growth in one country after
another
ii) ageing will affect patterns of national saving and borrowing, and
with these the directions and magnitudes of global capital flows
iii) through the saving and borrowing path the process can
influence values of key assets like housing and equities
iv) through changes in the dependency ratio, ageing will influence
pressure on global sovereign debt, producing significant changes in
ranking as between developed and emerging economies.

22. While population ageing is universal the short term impact will
be much more localised. The pace of aging varies greatly across
countries and regions.
The effects of the process are expected to be most pronounced in
those countries that remained complacent in the face of several
decades of ultra-low fertility rates (total fertility rates of 1.5 and
under), which in effect means Japan, China, South Korea, the
German speaking countries and much of Southern and Eastern
Europe.

23. Another way of looking at these demographic changes is in terms of the
dependency ratio, which can be defined in a number of different ways
depending on the problem being addressed. For present purposes what
matters is the old age dependency ratio.
Less developed economies tend to have high youth dependency ratios, and
as a result low savings rates. In mature economies the situation inverts –
there is a high and growing elderly dependency ratio, and demand for
private credit is weaker.
Those societies that are ageing more
rapidly have higher elderly
dependency ratios, and the
proportion of over 65s is growing
rapidly. The demand for pensions
and health care puts increasing
pressure on state finances, so the
demand for public sector credit rises.
Public debt is high – in Japan gross
debt is now around 225% of GDP, in
Italy it is 120% and in Germany 85%.

24. In some cases not only will population age, it will also
fall. In Germany total population is expected to fall from its current
level 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 just
under 20% today to just over 33% by 2050. At the same time, the number of
very elderly (those aged 80 and over) will nearly triple to as much as 15% of
the total population.

25. In Italy population is projected to remain more or less stationary, at
around 60 million, at least until the 2030s, but the age structure of the
population will be constantly shifting.
(Data: UN 2008 forecasts, median estimate)

26. One Key Shift Occured In The 1970s.
This Was The Point Where Each Generation Started To Get Smaller Than Previous One
Another Key Decade Comes In The 2020s. As the largest Population Cohorts Reach
Retirement AgeThe Elderly Dependency Ratio Rises Substantially

27. 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 have
Societies with large numbers of people
problems with innovation and creativity, and this issue is
between 35 and 50 are highly productive made worse if low growth leads highly educated young
people to leave.

28. All of which has to
be reasonably
obvious once you
have gotten the
basic idea.
Even the IMF seems Few seem to have noticed
The curious issue is why
to have failed to that the world has somehow
so few mainsteam
notice that changed since 2007. Most are
economists and policy
something “fishy” is simply waiting for things to
makers 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?

29. Is Italy Like Venice Sinking Steadily Into the Sea?
Italy’s famous “leaning
tower” has held upright
for nearly a thousand
years. It is unlikely we
will be able to say the
same about the country’s
unstable population
pyramid.
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 economic
growth rate to fund welfare costs. Italy needs economic and demographic stability and
sustainability.

30. Italian Fertility Has Fallen To and Remained Around 2/3 Replacement Level
Population Has Recently Grown Rapidly, But Only As A Result Of Immigration

31. There Was A Significant Increase In The Italian Workforce And – Before The
Crisis – In Employment
But Due To The Poor Productivity Performance And The Strength Of The Informal
Economy This Did Not Translate Into Increased Economic Growth

32. Italy’s problem obviously isn’t only demographic. If anything Italy’s demography has improved
slightly over the last decade even while the economic situation has deteriorated. In part this is the
result of a changed external environment. But there is obviously lots Italy could do to improve the
situation. Especially as regards the quality of its institutions.

33. 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

34. Italy Is Now Poised On A Knife Edge
Key Factors:
• Growth
• Inflation
• Interest Charges
Hence The Problem Of Market
Pressure, And Interest Rates.
The IMF currently predicts that
Gross Government Debt To GDP
will peak at 124% in 2013. Any
slippage on this and debt
restructuring becomes inevitable.
Investors Are Worried. Market As of June, Italian banks had borrowed more than
Responses are not just simple 283 billion euros from the ECBand part of which was
speculation. ECB support is critical, invested in high yield government bonds. Banks
but so are radical measures to increased their holdings of Italian bonds by about
increase the growth rate. 78 billion euros in the first half of 2012.

35. Too Big To Rescue?

36. 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 year
And there is at least another year of
the same or worse to come as
spending cuts steadily bite and the
Euro debt crisis rocks its way forward.
The recession will weaken tax
revenues and hit jobs and consumer
spending, a vicious circle which makes
it harder for Mario Monti, who is
aiming to cut the budget deficit to 0.1
per cent of GDP in 2014, to meet his
public finance goals.

37. Hard Times Ahead
Consumer Confidence and PMI
indicators suggest that the Italian
government’s GDP growth estimates
(of a contraction of 1.2% for 2012 and
an expansion of 0.5% for 2013) are
way too optimistic . The employers
group Confindustria now forecast a
contraction in GDP of 2.5% in 2012. A
further fall of 2.0% is not unlikely as
the European debt crisis worsens.
Compared to the other forecasters I
would be more negative on the
outlook for both private consumption
and investment activity. With a more
negative outlook for the euro area
economy – destination for 43% of
Italian exports — these are unlikely
to put in an unexpected stellar
performance.

38. Unemployment Rising Sharply
Italy's 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 either
The number of people living in
absolute poverty in Italy rose to 3.4
million in 2011, or 5.7 percent of the
population, up from 5.2 percent in
2010.Those living in relative poverty
for Italian standards were roughly
stable at 8.2 million, or 13.6 percent.
But among families with no workers
and no pensioners, the relative
poverty rate rose to 51 percent from
40 percent.

39. Fiscal Targets Look Increasingly Out Of Reach
The implementation of austerity measures in Italy is likely to have a substantial
negative impact on the economy in the coming years. Given its lack of
competitiveness, the economy lived off constant demand stimulus from the
government. Without this the growth problem is likely to become worse.
There have now been five fiscal packages since July 2011, aimed at a cumulative fiscal
consolidation of 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With the
majority of the measures concentrated in 2012, there will inevitably be a large
negative impact on the economy throughout this year. Given the deep recession the
country will be in over the next couple of years and poor potential growth prospects
over the medium- and longer-term, Italy’s public sector balance sheet problems are
likely to mount.
Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison with
many Euro Area countries the governments projection of a close-to-balanced budget
in 2014 looks hugely optimistic. A more realistic expectation would be for the deficit
to be under the EU 3% level at that stage, but the danger is this could well mean gross
debt to GDP will be over 130%. Above the danger mark.

40. 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 starved
This problem is more complex than it of credit as they face interest rates that
seems. It is not so much a question of are 30 per cent higher than the average of
credit being strangled, but of demand other sectors.
being strangled as austerity bites.
Companies who cannot sell profitably
are a high credit risk. There is demand
globally, but as I am saying Italy is
insufficiently competitive to take
advantage of it. The high cost of
financing Italian government bonds is
pushing up longer term interest rates,
and discouraging investment, and this is
an issue the ECB could address.

41. The Euro Area’s Single Financial Market Unwinding
Italian banks have borrowed more than 283 billion euros from the ECB via the 3
year LTROs and use the liquidity obtained to buy government bonds which pay
much 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 “crowding
out” comes.
Banks increased their holdings of the country’s bonds by about 78 billion euros in
the first six months of 2011. This forms part of the “nationalisation” of Europe’s
sovereign debt markets. Foreign investors cut their holdings of Italian government
securities 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.

42. The possible Italian bailout is
Easing 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 unemployment
need to “abolish wage indexation, relax job protection and cut minimum wages”, the bank
said in its August monthly bulletin. The bank is not impressed with the Italian labour
reform, which is too little too late, and thinks direct wage cuts are now the only remedy.
Unsurprisingly, many in Italy are
becoming reticent about handing over
their country’s future to an institution
with such views, and pressure is
mounting for Monti not to ask for
help. That having been said, the
country really has no alternative if it
wants to stay in the Euro.

43. 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 are
going to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he said
on a recent visit to Helsinki.
He was, of course, referring to the
ambivalence of Silvio Berlusconi on
the Euro issue, and the outright
hostility to the common currency
displayed by the rising (5) star of
Italian politics, Beppe Grillio. “After
me the populists”, as Monti once said.

44. Structural Reforms

45. Dangers of Sovereign Debt Default?
According to a recent Standard & Poor's report, the timing of the
current debt crisis is not a coincidence since cost of caring for the
growing numbers of dependent elderly will both affect growth
prospects and dominate public finance policy debates across the
globe, and for many years to come.
Even if most governments have long been aware of the need to
prepare for the looming problem, the rapid build-up of
government debt over the past three years has effectively
heightened the need to do more to advance reforms aimed at
containing the risks to sovereign budgets, especially in
countries with high expected future increases in age-related
spending.

46. A Delicate Balancing Act
Reasonable empirical confirmation exists that the recent
surge in global imbalances was, in part, an offshoot of
slow-moving underlying demographic determinants of
global capital flows.
The near-term adjustments will mean more emerging
market current account deficits and less developed
market ones.
At a global level, demographic pressures will continue to
imply that the increase in desired saving will exceed the
increase in desired investment. This has one clear
implication: globally interest rates can be expected to
remain low.

47. Longer, Healthier Working Lives
In terms of policies to address the pressures of ‘ageing’,
the debate in terms of social security and healthcare often
focuses on raising retirement ages to reduce dependency
rates and alleviate fiscal pressures.
Extending working lives relative to the time spent in
retirement will not only help address the pension issue, it
should also serve to accelerate the tendency towards
larger current account surpluses across most developed
economies, in particular in those parts of Europe which
are in the process of private sector deleveraging as part of
their fiscal sustainability programme.

48. 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.

49. Thank You For Your Attention