By Luigi Zingales* – Foreign Policy
Italians are rearranging the deck chairs as their country irrevocably sinks.
A few weeks ago, an Italian magazine asked me to illustrate graphically how I see Italy from abroad. I am incompetent at drawing, but an image instantly popped in my mind: the Costa Concordia shipwreck in the Mediterranean Sea in 2012. Italy, too, is a beautiful ship slowly sinking because of the ineptitude of its captain — or captains, as it were.
Surprisingly, this is not the view most Italians have of their own country. Most recognize the Italian ship is taking water on board, and that in theory it could sink by defaulting on its public debt. But Italians have faith that the Stellone Italiano (the Italian lucky star) will save them at the last minute, just as it has historically bailed out the Italian soccer team in World Cup matches.
Yet, just as the Italian lucky star seems to have abandoned the national soccer team, which failed to qualify for the upcoming World Cup for the first time in 60 years, it might also be inadequate as Italy approaches the astral combination of three crucial events: the end of monetary quantitative easing, the possibility of a U.S. recession (which some forecasters estimate at 50 percent in the next two years), and the national election on March 4.
The latter is the only event within the direct control of Italians themselves. But looking at the economic platforms of their various political parties, there’s little reason to hope they will take this last chance to save their country.
A light at the end of the tunnel?
My image might appear unjust. People in the United States are familiar with high-quality Italian exports, not only in fashion and food (the success of Eataly is an example), but also in high-tech manufacturing, from Ferrari to Technogym. If you are lucky enough to travel to Italy, you will find a beautiful country with high standards of living and lovely people. This rosy picture is also supported by recent economic data. In 2017, Italian GDP grew 1.5 percent, industrial production was up 4.9 percent, and Italians are now feeling — for the first time in a decade — more optimistic about their future. So why do I portray Italy as a sinking ship?
What is jeopardizing the future of Italy is a lethal combination of four factors: lack of productivity growth, a very negative demographic outlook, oppressive levels of public debt, and a political impasse in the eurozone that on the one hand puts the country at continuous risk of speculative attacks, and on the other makes election superfluous, engendering a sense of loss sovereignty that fuels nationalism and populism.
Why productivity growth halted
In the 1950s and 1960s, Italian productivity (output per hour worked) grew faster than most advanced nations, generating what is commonly known as the “Italian economic miracle.” In the 1970s and 1980s, in spite of high inflation and social tensions which led to a serious terrorism problem, Italian productivity grew in line with most developed nations. Yet in the mid-1990s, Italian productivity stopped growing. This phenomenon predated the 2008 financial crisis and persisted afterward. As a result, Italian per capita income today is no different than a quarter-century ago. What can explain such a sudden stop?
Opponents of the euro blame Italy’s productivity stagnation on the fixed exchange rate imposed by the common currency. While the inability to devalue might impact the amount of export, it is not obvious why it should impact productivity. In fact, the competitiveness lost in the exchange rate should have pushed firms to increase their efficiency. If the euro is to be blamed, the only possible channel is through demand effects: the combination between demographic stagnation and export decline might have curtailed new investments, reducing the embedded technological improvements that would have come with new machines.
However, Italian problems are deeper than the euro. As Bruno Pellegrino and I have shown, the lack of productivity growth can be blamed on two main factors: low capital investments and an inability to exploit the information and communication technology (ICT) revolution that hit the Western economies in the mid-1990s.
It is easy to explain the low capital investment with the Italian distorted tax system that taxes productive capital more than financial and real estate investments. But why was Italy unable to take advantage of the ICT revolution?
Several studies show the complementarity between merit-based management and ICT investment. Compiling data on performance is of little value if workers are not compensated and promoted based on performance, but rather for loyalty owed to their boss. Italian small and medium enterprises are controlled by old patriarchs who value loyalty more than performance. Large Italian firms are controlled by the government or severely influenced by the government, and political affiliation matters more than performance. In other words, the lack of meritocracy pervading the country has jeopardized its ability to take advantage of the ICT revolution.
One of my favorite lines — which greatly endears me to the Italian establishment — is that Italy is the country with the smartest secretaries and the dumbest managers. This outcome is not just the result of bad luck, but of lack of meritocracy. If you are not born in the right family, if you are not politically connected, and especially if you are a woman, you will find the career ladder blocked. By contrast, well-born charming men can easily make it to the top, even when they lack the necessary talents.
No country for young men (or women)
In Goethe’s masterpiece The Sorrows of Young Werther, the protagonist commits suicide not just for the pain of love, but for the lack of hope. Born bourgeois in an aristocracy-dominated society, he saw no opportunity for social promotion.
Young Italian people face similar despair. If you are honest and bright your best chance is to emigrate. While youth unemployment has declined in the last year, still one out of three people between the 15 and 24 years old is without a job. Even those who are lucky enough to have one, tend to have temporary positions, are paid poorly and lack stability. Selection is based more on who you know than what you know. The best student in my high school class in Padua, who went to the best university in Italy and later earned a doctorate in the United States, is still a high school teacher in Italy. My young niece, with a pharmaceutical degree, was shocked to see how nurturing American doctors are of young pharmacists and how and respectful they are; in Italy she was belittled when not harassed.
In 2016, 124,000 Italians between the ages of 18 and 34 left the bel paese, roughly 2 percent of the population in that cohort. This is the reason why talented Italians populate American universities and firms all over the world: They find a way to emerge which they cannot find at home.
This lack of meritocracy has not only hampered productivity and induced the brightest and more dynamic young people to leave; it has also reduced fertility. When young people are unemployed or poorly paid, how can they afford to have children? By the time they can afford to start a family, they are too old to do so. In the United States my son could support himself completely and choose to get married at age 24. Who could do the same in Italy? As a result, the fertility rate in Catholic Italy is only 1.37 births per woman, well below the rate of 2.1 needed to maintain the population at its current level.
Lack of productivity growth, lack of population growth, loss of talent, and now an increased opposition to immigration make the Italian public debt difficult to sustain. Unlike personal debt, government debt does not need to be repaid; it can be rolled over as long as a government is able to pay the current interest and the market expects it will continue to do so in the future. For that to hold, the ratio between debt and GDP must not rise in perpetuity.
In practice, that condition depends upon two factors: the size of the government’s primary surplus (the difference between the tax revenues and government expenditures other than interest expenses) and the difference between nominal interest paid and nominal growth of GDP. Large primary surpluses are difficult to sustain, both economically and politically. Thus, the difference between the nominal interest rates on debt and the growth rate is crucial.
This condition held in 2017, yet for only the first time in a decade. And it was due to the lucky coincidence of three factors. First, Italy was increasing its capacity utilization after years of recessions, generating a real growth rate above what can be expected in the long term, when the real growth rate is driven only by productivity growth and the growth in the number of existing workers. Second, Italy was greatly benefiting from U.S. and European expansion, which increased demand for exports and from relatively low oil prices that increased the competitiveness of its export. Third, the interest cost on the government debt was kept artificially low by the massive purchases of government debt undertaken by the European Central Bank through its quantitative easing (QE) program.
Were any of these lucky factors to disappear, the sustainability of the Italian debt would be jeopardized
And we know that QE is unlikely to continue beyond the current year and several forecasters put the odds of a U.S. recession in the next two years at 50 percent. Therefore, in the next few years Italy will have to navigate between the Scylla of the end of the quantitative easing in Europe, which will lead to higher interest rates, and the Charybdis of a U.S. recession, which might lead to lower growth. Either one could be fatal; the combination of the two will be absolutely lethal. If the market perceives Italian debt to be unsustainable, there would either have to be a European bailout or Italy would be forced to exit the eurozone. Thus, it would be obliged to choose between Greece’s fate of recent years or Argentina’s in 2001.
Despite all these risks, the interest spread between Italian bonds and German bunds hovers around 140 basis points, a low level for a country that has seen its debt-to-GDP ratio continuously increase in the last 10 years to a whopping 133 percent. If the situation is so dire, why are not only Italian voters, but also international financial markets so complacent?
The answer is very simple: They have all learned the lesson of the past euro crisis. In 2011, the Italian government debt market was hit by a crisis of confidence. The additional interest (spread) investors were demanding to invest in Italian debt skyrocketed in a few months from less than 200 basis points to 554. Between November 2011 and June 2012, the country did everything it could to improve its fiscal situation by passing a very tough pension reform and overseeing a significant increase in the primary surplus. Yet, in July the spread was still around 500 basis points. It was only when the European Central Bank President Mario Draghi promised to do “whatever it takes” to save the integrity of the euro (and so the survival of Italy in it) that the spread started to decline, shrinking even further with the beginning of the QE program.
The lesson learned here is that Italian policies do not matter, only those of the ECB. This lesson cuts two ways. First, even if the antiestablishment parties win on Sunday, they will find it impossible to govern without the ECB’s consent. Thus, the European Union and the ECB will ultimately shape Italian economic policy, as we have seen in Greece. This is the reason why the markets are so calm. But this is also the reason why nationalist and populist sentiments are rising in Italy. If voting does not impact economic policy, why not use it to express frustration? And frustration against Europe runs high, especially due to the way it dumped the responsibility of dealing with the immigration flow on frontier countries like Italy and Greece.
The second lesson learned from the crisis is there’s no clear reason a government should cut expenditures and raise taxes if this effort can be easily undone by decisions made in Europe. For example, the former German Finance Minister Wolfgang Schäuble wanted to impose a form of bail-in even for government debt (which will force losses on Italian debtholders before accessing any European help package). If European officials begin to seriously discuss this possibility, it could trigger a panic in the Italian debt market — a panic that would easily destroy years of hypothetical economic sacrifices.
A surreal election
With these incentives, even Scandinavian politicians would behave in a shortsighted manner; Italian politicians are considerably less restrained, without understanding that the Italian economy cannot function outside the European market, but that the rules in place — which allow a German politician’s musings to threaten Italy’s basic sustainability — make it difficult for Italy to survive within the euro area. The only hope is a renegotiation of the rules between Italy and its European partners. But no party has a plan on how to go about doing it.
Almost all the major platforms demand an increase in government expenditures, which will only worsen the Italian fiscal situation. The antiestablishment Five Star Movement is the only party that seems to put at the forefront the problem of corruption and lack of meritocracy in Italian society. Yet, it is not clear how it proposes to address these problems it if it were to win the election outright.
This is practically an impossibility, in any case, since the present government changed the electoral law in October to essentially require any future government to be a coalition between parties. This arrangement gives incumbent parties greater power; since these are the parties who have abetted all of Italy’s endemic problems, it also jeopardizes any possibility of serious reform. After the election, the likely kingmaker will be Silvio Berlusconi, resurrected as the “wise and reliable leader” despite a criminal conviction for tax fraud, which prevents him from holding any office until 2019.
The boiled frog
Lore has it that a frog put in a pot full of cold water will not jump out even when the temperature rises gradually, resulting in it being boiled alive. Italy risks the same fate. The pot is the debt burdening the country, but Europe controls the temperature. It does not want to raise it enough, because it fears the spillover of a crisis. But it has no interest in cooling it down, because this will take away the incentives for Italian politicians to act wisely (or at least so Europe thinks).
Some cynics claim that cooking Italy slowly greatly benefits Germany, the hegemonic country in Europe, which gets the best and the brightest young Italians in its workforce and can suffocate its most competitive rivals in manufacturing. But never attribute to malice what can simply be explained with inertia. Italy’s trap is a combination of its poor economic conditions and the European rules to which Italy has willingly agreed. It is too easy to blame others after the fact.
Will the election change anything? I do not think so, and neither does the market. Italian decline is likely to continue slowly and inexorably, gradually accelerated by decisions made elsewhere. To borrow from Franklin D. Roosevelt, the only thing to fear about Italy is a lack of fear itself.
*Luigi Zingales is Robert C. McCormack professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business, and host of the podcast Capitalisn’t.