Could Italy be the Next Greece? A Debt Crisis is a Growth Crisis

Ashoka Mody Princeton University and Bruegel March 27, 2015

The Euro’s Lost Children: Evolution of Euro Area GDP 50% Ireland, 42%

40%

30% Spain, 25% 20%

France, 18% Germany, 17%

10% Portugal, 3% Italy, 0% Greece, 0%

0%

-10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: OECD. This is an extended version of a graphic that appeared in Der Spiegel.

The Hoped-for Growth Continued to Elude … Persistent austerity dented already weak growth potential Greece

Italy 2.5

6

2

4

1.5 1

2

0.5

0

0 -0.5

-2 -4

2010

2011

2012

2013

2014

2015

2016

-1 -1.5 -2

-6

-2.5 2010

-8 April 2011

April 2012

April 2014

October 2014

Source: IMF, WEO Databases, various vintages, http://www.imf.org/external/ns/cs.aspx?id=28). Note: Dashed lines refer to projections at the time

2011

April 2011

2012 April 2012

2013

2014

April 2014

2015

2016

October 2014

…and, thus, Public Debt-GDP ratios Kept Rising Greece

Italy 140.00

180.00 170.00

135.00

160.00 130.00 150.00 125.00

140.00

120.00

130.00 120.00 2010

2011

April 2011

2012

2013

April 2014

2014

2015

2016

115.00

October 2014

Source: IMF, WEO Databases, various vintages, http://www.imf.org/external/ns/cs.aspx?id=28). Note: Dashed lines refer to projections at the time

2010

2011 April 2011

.

2012

2013

April 2014

2014

2015

October 2014

2016

And Unanticipated Rise in Debt Correlated with Unanticipated Fall in Inflation Debt-Deflation Dynamics: the relationship between unexpected changes in the debt-to-GDP ratio and unexpected changes in inflation 1

Estonia 0.5 0 Unexpected inflation

-10

-5

5 10 Luxembourg Austria Finland -0.5 Germany

Latvia

0

15

Ireland Belgium France -1 Netherlands Malta -1.5 -2 -2.5

20

25

30

Portugal Italy

Greece

Slovenia Spain

coefficient = -0.029 (t-stat: -2.07) R² = 0.2214

Slovak Republic Unexpected change debt-to-GDP ratio

Source: IMF, WEO Database, April 2011 and April 2014.

• Deflationary tendencies were not uniform across the euro area. • This correlation suggests that the dynamics of rising debt and falling inflation were related. • Austerity to reduce debt, lowered growth, raised debt, and reduced inflation. • But lower inflation feeds back to higher debt burden…debtdeflation cycle?

Italy on a Falling Growth Trajectory: Has Not Invested in its Future—decades’ old problems, could take years to resolve Percent of labor force with Tertiary Education, deviation from Sweden

Average per capita GDP growth rates, 1951-2011 Deviation, % of labour force

6.00

percent growth

5.00 4.00 3.00 2.00 1.00

0 -2 -4 -6 -8 -10 -12 -14 -16 -18 -20

1995

0.00 1951-74 France

1974-90 Italy

1990-99

2000 Year

1999-2011

Sweden

The Italian “miracle” was as much a bounce back from the war devastation…

2012

France

Italy

Italy lags in all human capital and innovation indicators. Has high tertiary educated emigration. Population aging: young unemployed. Hence lags in productivity growth.

One-Variable Forecast of Italian per Capita Income Growth 8.00

Italy per capita RGDP growth rate, %

1946-1970

6.00

4.00

2.00 1930-1939

1900-1913 1890-1899 1971-1990 1920-1929 1991-1998 1999-2008

0.00 2009-2011

-2.00

-4.00

2012-2014

World average trade growth, %

1890-1990

1991-2014

The world trade-Italian growth curve shifted down in 1991. Another downshift now?

Italian Debt Prospects • Compare 1995-1999, exactly twenty years ago on eve of euro entry: Italian debt ratio fell by about 7 percentage points from 120 to 113. o Primary surpluses in the 4-5 percent range o World trade growth >7 percent. o Inflation around 2½ percent. o Moreover, many think Italy cooked the books in 1997-1998 • Between 2015 and 2019, debt-to-GDP ratio projected to fall from 136 to 125 percent And IMF Forecast What If? What If? Primary Rising to 3-5%, average 4½ percent ~2 ~1% Surplus percent World Trade Rising to 5-6% 4-5% 3-4% Growth Inflation Rising to 1½% ~1% ½% Debt-GDP Expected fall completely unrealistic, Gently And ratio austerity would kill growth/inflation rising faster still • Reinhart, Reinhart, and Rogoff (2015) find over a 200-year history: o 20 percent of high-debt cases during peace times end in restructuring.

Two Countervailing Forces • Low interest rates o Assuming that Italy does not fund itself with short-term debt, real interest rate still positive and, at this point, higher than GDP growth rate o How the two will move is an interesting question • Outright Monetary Transactions o The ECB has “lender-of-last resort” capacity o Not quite: the ECB has “conditional lending” capacity o Therefore, will depend on program negotiated with ESM o And capacity of ESM o And if QE has required national central banks to bear the risk, will OMT also do that? o And, if so, as one unnamed veteran sovereign debt attorney has asked: will the markets test the political legitimacy of that arrangement “mercilessly?”

Reflections on Greece in the Days before the Rescue The Wall Street Journal on Greece, April 30, 2010 “[Those] who dominate today’s economic decision-making seem to believe that Greece merely has a liquidity problem that EU cash can solve. The unhappy reality is that Greece is busted and its political-economic model has reached a dead end.” Having concluded that Greece was insolvent, the article went on to say: “If a debt restructuring is inevitable, then it’s far better to accept the pain now and get it over with.” Arvind Virmani, the Indian Executive Director to the IMF, May 9, 2010: “Even if, arguably, the program is successfully implemented, it could trigger a deflationary spiral of falling prices, falling employment, and falling fiscal revenues that could eventually undermine the program itself. In this context, it is also necessary to ask if the magnitude of adjustment…is building in risk of program failure and consequent payment standstill…. There is concern that default/restructuring is inevitable.”

Lessons • The Greece situation has become pathological o Its resolution now lies in the political realm. • Like Greece, Italy has no growth model: o no amount of wage reduction will make it competitive with the low wage countries; and o it is already running behind China in human capital and R&D; and o Vietnam will soon be there. • A policy of austerity on a weak economy is doubly counterproductive • To come out safely at the other end, Italy will need to pass over a razor’s edge.