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Train of thought

Italy is heading slowly towards a crash unless it takes steps to improve growth

Italy is a slow-moving train crash. It may lack the immediate sense of crisis that assails other econ-omies but the sad truth is that Italy needs strong sustainable real GDP growth to escape the peripheral spread burden. Its legacy debt burden is easily manageable if the economy achieves escape velocity from its lost decade of growth.

We do not expect Italy to achieve materially positive real growth in the current decade in the absence of significant labour and product market reforms. The consequences of a decade characterised by volatile inflation and limited expansion are shorter and more synchronised business cycles. This means that the contractions in activity during these recessionary periods are likely to offset the cumulative impact of very weak real growth recorded during these short business cycles.

The European sovereign debt crisis has placed the other peripheral economies in the intensive care of core nations.

Greece, Portugal and Ireland are dependent on injections of funds from the EU and IMF and liquidity from the ECB. Spain is in the waiting room liable to relapse over the summer as more accurate estimates of its regional government and housing debt become available.

Unless the government acts quickly to reform its labour and product markets, Italy does not need this peripheral hospital – it requires a hospice.

The Italian government’s economic record has been mixed, to say the least, over the past few years. While it has recognised the danger of expanding fiscal policy and is committed to reducing its deficit over the next three years, it has been slow to achieve the necessary labour market reforms required to raise Italy’s woeful productivity performance.

Italy’s growth performance over the past decade has been less than half Japan’s real growth performance over the period although it has been better in nominal terms because of higher domestic inflation.

It shares two important factors with Japan, namely, the aging population and high domestic ownership of government debt. The latter is important because there is a clear correlation between the rapid deterioration of the sovereign debt crisis over the past two years and the relative share of external investors’ ownership of the government debt markets.

The high level of domestic savings and participation in the government bond market cannot be taken for granted, given the reduction in personal savings during the last few years. For the time being, it provides insulation against a rapid escalation of Italy’s problems. However, the aging population with the resulting decline in working age population means that improving productivity growth is even more urgent.

Weak productivity growth in Italy has contributed to rising unit labour costs and loss of competitiveness. During one of the strongest periods in history for global-isation, Italian exports have provided a negative contribution to growth.

This long, lingering death means that Italian government bond spreads will continue to shadow Spanish govern-ment bond spreads. However, the amplitude of this will be smaller, allowing Italy to continue to outperform Spain over the next 12 months.

Italy shares Japan’s slowmoving crisis but, unlike Japan, does not have domestic monetary or foreign exchange flexibility. By the end of the decade, if not before, Italy will be faced with substantial debt devaluation or forced exit from the single currency.

The obvious rebuttal of this view is that Italy’s prolonged period of weak growth in combination with inflexible labour and product markets provides an opportunity for mean reversion of its growth rate. Even modest deregul-ation will lead to a significant improvement in growth.

There is clearly potential for faster growth but to achieve it would require a triumph of hope over experience. Italy’s convoluted political system is not conducive to radical change and dominance by special interest groups is unlikely to change until the country reaches a real crisis in the aftermath of its exit from the single currency.

By 2030, on current projections, Italy will have just two people of working age for every person aged over 64. You do not need to be Paul McCartney to realise how difficult it will be to generate strong sustainable growth in this environment.

Stuart Thomson is chief economist at Ignis Asset Management

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