Tuesday, November 15, 2011

Mario Monti's Challenge

The likely new Italian Prime Minister Mario Monti has some serious challenges to meet. The fiscal challenges are well known. The bigger challenge will be to turn around long-term economic under-performance in one of the world’s largest economies.

Unlike Greece, which has a solvency problem, Italy’s fiscal crisis is one of liquidity. That being said, if a liquidity crisis is not dealt with effectively, it can become a solvency crisis.

Italy’s budget deficit this year is estimated to be around 4% of GDP. After accounting for interest payments, that’s a primary surplus of around 0.5% of GDP. Some commentators have argued recently that the primary surplus means Italy’s deficit is not as bad as it looks. Sorry, but a deficit is a deficit.

Italy has public debt of around 120% of GDP. The duration of that debt is quite long (7 years) by comparison with other countries, but there is approximately €350 billion in bonds that will have to be refinanced in 2012.

At issue is the level of interest rates Italy has to pay to finance that debt. Ten-year bonds at 6.5% (and higher again last week) make Italy’s debt dynamics unsustainable. Achievement of a balanced budget (or primary budget surplus), or at least a credible plan to get there, is essential to bring interest rates down. Measures passed last week before the resignation of Prime Minister Berlusconi look likely to achieve that goal, but not before 2014.

The bigger problem, which in our view must be sorted with the same level of urgency, is Italy’s poor economic growth performance. As we’ve commented before, the long-term answer to reducing Europe’s debt burden is stronger economic growth. That’s why we have always argued there needs to be an appropriate balance between achieving fiscal sustainability and supporting economic growth.

Italy’s economic track record is woeful. Trend GDP growth is probably no better than 1% per annum. The challenge is best exemplified by its recent performance on productivity. According to OECD data, Italy is the productivity laggard of Europe with a performance well behind that of Germany, the United States, and Europe as a whole. In fact productivity in Italy has gone no-where in a decade.

Therein lies Mario Monti’s biggest challenge - instituting structural reform that grapples with an inflexible labour market and a stifling bureaucracy. These are just as critical to Italy’s long-term health as dealing with the more immediate challenge of achieving fiscal sustainability. The other challenge is that by their very nature, structural changes take time to have an impact, and the near-term impact can be negative for both employment and economic growth.