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Italy, the Sick Man of Europe

Italy’s economy has been underperforming due to a wide array of structural problems within the system.

Italy is the third largest economy in the eurozone, and its nominal GDP represents the 12th largest in the world. However, Italy’s economy is smaller than it was in 2008 and is still grappling with many shortcomings that drag down its capability. Regardless what coalition or party will run the next government, Italy has to implement reforms aimed at reviving productivity, downsizing public sector inefficiency and eventually reducing its debt to GDP ratio. Simultaneously, regulatory reform and competition policy are a sine qua non to shift resources away from non-productive sectors and drive investment toward more dynamic and high value-added areas.

Different variables come into play when explaining total factor productivity (TFP). First, the driving force behind TFP is the investment in human capital and knowledge. It is statistically demonstrated that the value added by work input raises according to the skills incorporated within the workforce; the more educated and high-skilled the workforce, the higher the productivity and the value added to the final output. As Enrico Moretti argues in his book, The New Geography of Jobs, intangible assets such as ingenuity and adroitness of human capital lead a country to move toward its technological frontier.

Econometricians and statisticians have shown how, in developed economies, “the organizational complements to firms’ installed computer-skills, organizational structures and processes, culture, and other factors” raise or decrease productivity, accordingly. With this respect, Italy lags behind its European and global peers. In terms of European and global education standards, Italian students rank below average; in addition, graduate-student rate among 25 to 64-year-olds is around 17%, compared to Germany’s 27%, 32% in France and 44% in the US. Here the problem lies in low levels of spending on tertiary education and in money being wasted in the allocation of resources.

The second driver of growth and TFP is saving and investment in capital stock. Alongside human capital, an increase in capital deepening, namely the growth in the physical quantity of capital available for a single worker, is strongly correlated with total factor productivity growth. As shown by Luigi Zingales and Bruno Pellegrino in their study of Italy’s labor productivity, “poorer management practices are the cause of this disadvantage, raising the possibility that the Italian disease is just an extreme form of a European disease.” With regards to this, capital accumulation and investment rates in Italy are falling behind, due to specific features of the country’s business ecosystem. It is weighed down by small and medium-sized enterprises that rely on familial networks and cronyism, firms that are resistant to new technology, narrow mindedness and low levels of meritocracy among managerial staff, plus a high corporate tax rate, all of which inhibit entrepreneurship and investment.

The third and last factor is innovation. Innovation rests on uncertainty, human creativity and chance. It concerns product and process innovation, and implies the adoption of disruptive technologies, new methods and procedures that increase the value and the quantities of the final output. All other inputs being equal (capital and work), technological breakthroughs that stem from innovation incorporated within the work process improve quality, reduce marginal costs and have positive effects on productivity. R&D spending and investment in frontier research opportunities by venture-capital firms are the main source of growth. With regards to this, Italy has gone through a negative rate of growth since 1995. To make matters worse, TFP has dropped by 0.6% on average. Again, the research carried out by Zingales and Pellegrino finds a robust correlation between low levels of technological innovation and a failure to “take full advantage of the ICT revolution.”

Public Sector Woes

Italy has a long history of public intervention in the economy. In one of the most comprehensive and detailed studies of Italian economy, Fabrizio Barca stressed two features of local capitalism: the presence of lobbies and corporations and the “role of the Entrepreneurial State.” Italy’s entrepreneurial mindset continues to heavily leverage on corporatist benefits and rent-seeking behavior guaranteed by vested interests, where competition and the market economy are portrayed as an absolute evil, while protectionist measures are implemented to secure special interests to the detriment of collective economic growth.

Trade unions play their role in this dismal situation, seen mostly as an expression of the interests of older workers and pensioners. Plus, they are bound to the concept of collective and national bargaining typical of the industrial-manufacturing period, made up of mass production and assembly lines and anchored to a militant vision of limited labor mobility, preference for lifetime employment and job security.

With regard to the bargaining power of lobbies and their vested interests, the Alitalia case provides an apt example. The national airline that recently filed for bankruptcy — it has done so already in 2008 and seen a number of public recapitalizations over the last 30 years worth €7 billion ($8.7 billion) — has been bailed out many times without incurring any corporate restructuring program aimed at modernizing it. Several attempts made by foreign companies and private equity firms to take over Alitalia were foiled by unions. In addition, unions and the company’s management have always relied on government promises to come to rescue the “national pride” embodied by the airline, regardless of the burden on taxpayers, all of this following the logic that the liberalization of the airline would break electoral consensus for the government and would jeopardize job security.

This last example highlights the second feature of Italy’s economy brought up by Barca, namely the role of state as entrepreneur. The Italian entrepreneurial state has often leveraged on the use of public debt to allocate resources and achieve consensus in a typical do ut des — quid pro quo —policy. Over the last 40 years, especially in the 1970s and 1980s, Italy’s current account has run on a large deficit, above all in order to pay for a skewed pension system, and a massive amount of debt has run up to the detriment of future generations. With regard to this, it was in the aftermath of the crisis of 1992 and, above all, after the debt reduction reforms needed to meet the criteria to enter the Economic and Monetary Union, that Italy began to adjust its macroeconomic imbalances in the current account, especially in the field of pension reform.

However, Prime Minister Matteo Renzi’s flagship income-tax cut has been labeled as one amongst the last measures that fall within the do ut des policy. Notwithstanding that public intervention is always portrayed as a tool to fix imbalances, it’s mostly driven by political interests that eventually contribute to misallocation of resources, creating inefficiency and, last but not least, increasing ethical problems, with little regard for collective interests and economic growth. Indeed, many authors have criticized Renzi’s income tax cut “aimed at giving those earning €8,000-26,000 a year a tax cut worth €80 per month” since it would not lower the debt to GDP ratio but merely create a consumption boom.

Flawed Measures

The measures taken thus far to improve Italy’s economic performances are flawed. Renzi’s government has implemented the Jobs Act, aimed at bringing the Italian labor market closer to the labor flexicurity model to improve the entry and exit flexibility, enhance labor reallocation, reduce duality and promote stable open-ended employment. However, distortions continue to exist in the job market in terms of highly centralized wage bargaining structure and severe restrictions on dismissals (especially in the public sector), high taxes, skills mismatches between graduates and over-45s and poor governance of youth apprenticeship programs.

In addition, Italy still faces major structural issues that drag down economic performances and decrease productivity, such as a gargantuan public debt, its political use of vested interests and rent-seeking mentality by lobbies and corporations, not to mention an unsustainable pension system that continues to transfer present wealth to the elderly at the expense of today’s youth. All these factors taken together result in reduced economic efficiency through poor allocation of resources and low growth levels for the entire economy. For Italy to continue on a long-term path of growth and to avert a debt burden that could eventually result in a sovereign debt crisis in light of a tapering of the quantitative easing program implemented by European Central Bank, it has to follow through with its homework and adopt restorative measures.

First and foremost, more strategic investment in schools and universities, with a particular focus on the quality and high standards of teachers and academics, is imperative. Indeed, investment in human capital is the best predictor for economic growth in terms of high salaries both for individuals and communities. As compellingly demonstrated by the findings of Moretti’s research, investment in human capital does not only raise return on the skilled workers and productivity, but it raises income for the low-skilled workers as well thanks to complementarity — better technology and human capital externalities.

Second, Italy has to turn its public sector upside down and continue on the path of Fornero’s pension reform. Simply put, spending needs to be cut by 5% to 10%, the sprawling bureaucracy and share of pension expenditures have to be reduced alongside enforcing rules to eliminate corruption in public office. In addition, Italy should shift expenditure away from public consumption and drive toward public investment. Plus, Italy has to comply with and implement the Bolkenstein directive designed to open up competition within the service sector and to break up monopolies. This is the only way to root out longstanding inefficiencies that continue to slow down the implementation of reforms, deter investment and create scope for rent-seeking.

Last, in order to create a business ecosystem that encourages and rewards innovation, Italy has to cut taxes to support employment while switching subsidies from unproductive jobs and areas of backwardness to ecological niches of excellence. At the same time, it has to give more support to re-training of the unemployed. If these reforms are implemented, Italy may be set on its way to recovery from being the sick man of Europe.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

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